All Forum Posts by: Pablo Madrid

Thanks for the response. Really that 12 month new construction time frame is the kicker here on if the non-eligible gain is minor or almost 1/3 of the profit as you noted. Would like to get to the bottom of this last hanging question but seems like the conservative route may be the way to go.

I am buying a house next month with a rental on it primarily for the land value (urban Houston). There is a month to month tenant on the property which I will keep to offset holding costs while I design the home and I close on my bank loan for new construction. The hold time will likely be 3-4 months until the new construction loan closes. At that point I'll kick out tenant, tear down/move the house and build new construction which I will move into about 12 months later. I plan to live in the house 2-3 years and sell for a tax free profit from a section 121 exclusion since it will be my primary house.

I have multiple rent homes some generating a tax profit by now so writing off expenses on the 3-4 month hold cost at this rented house is worth something to me. Appraiser said structure is worth $5k so my depreciation is negligible in this timespan. Haven't found this situation online yet as most people don't tear down a rental but this is in a HCOL urban neighborhood where new construction comps are high and I got a good deal on the lot.

My questions are:

1) Assuming the timeline above, 4 months rental, 12 months personal home construction, 24 months primary residence then sale for 121 exclusion, how does the non-exclusion-eligible taxable portion prorate? 4/(4+12+24) = %10 of profit to be Long Term gains taxed? Or because the original structure is worth basically nothing and I'm building new is 100% of the profit eligible for 121 exclusion since I will live there 2+ yrs? Does the construction period count as part of my 2 yr test for 121 exclusion?

2) I have other SFH rentals I just Schedule E and that's it. So do the rental losses get to offset other Sch E income when I tear down and build new? (assuming I Schedule E this property for the 3-4 months it's a rental)

3) is this all too much headache and is the $800 bucks a month income not worth the blip/headache to my Schedule E portfolio even though taxes, interest etc could be a write off for those months?

Thanks!

Michael... you are the MAN! Great answer and i would likely avoid the boring complication you described in the future by making a judgement call which is simpler, "cat peed on carpet". Only thing i didn't realize is that the $15k loss in your scenario now deducts against my other passive RE income rather than the cap gain basis (i really do win!). This makes me more sure to take the DMSH.

I started RE Investing last year and I'm now up to 4 rentals cash flowing great. this is my first year doing rental taxes and this issue was my last hangup before classifying my expenses. 

Really appreciate the thoughtful response.

Thanks Eamonn. I think what i hear you saying is that most CPAs put the price increase to the building and then it's the more favorable treatment of having just the $8,000 of capital gains without the ordinary income liability of the sold but DMSH expensed carpet. Your reference to 1245 property took me to the website below which gave me the clarity i needed by saying 

" Section 1245 property is not land or land improvement, nor its buildings or inherently permanent structures, nor its structural components. Examples of property that is not personal property are land, buildings, walls, garages, and HVAC."  https://www.investopedia.com/terms/s/section1245.asp

This question wasn't just about $2,000 carpet but also $1,600 granite, $800 ceiling fans, $400 recessed cans and more which were multiple items as different UOP which were part of a $18,000 rehab which thanks to DMSH expensing can be expensed and "forgotten". Of course asking the question in that way would have been far too busy and i wanted a simpler answer to a specific tax planning issue. 

I knew DMSH had no depreciation recapture but if it did have "ordinary income" implication that would have caused me to rethink the election.

I have some expenses which could go either way on de minimis safe harbor or to capitalize and depreciate to deduct. Assume i bought a rental house for $100,000 on Jan 1. Land is worth $10,000 so depreciation is $3,272 in first year. Also i replace carpet in a few rooms totaling $2,000. Assume rent income is a breakeven against maintenence and depreciation so no gain or suspended loss carryover. Now I can de minimis safe harbor expense the carpet and net of my activities that gets me a $2,000 carry forward loss.  Assume i sell the property on Jan 2nd of the next year for $110000 sale basis (exclude fees for simplicity). I would pay depreciation recapture of 25% on the $3,272 ($818) and also long term capital gains offset by carry forward loss which is ($110,000-$2000-$100,000) = $8000. I am in 35% tax bracket so my Cap Gains rate is 20% thus i also owe 20% x $8,000 = $1600. Is this correct? I have read some where  that selling that DMSH expensed carpet is actually a $2,000 increase to ordinary income in which case i also owe an extra $2,000 x 35% = $700 (i think now by sale basis is $108,000 since $2,000 of it is for the carpet and thus cap gains is only $6,000). Or does the IRS forget about that "off books" asset and the $2,000 sale of the fully expensed carpet gets ignored?

If it is ordinary income than i would rather 100% bonus depreciate the carpet in which case my capital gain is still only $8,000 x 20% but not the carpet is just depreciation recapture at 25% which is less than my marginal tax rate. 

I understand carpet can also be depreciated over 5yrs so does that play into either election/tax scenario. I also understand the benefit of 199A bonus depreciation impact on QBI but that doesn't provide me any extra benefit in this case. 

Scenario above is more simple than mine but i'm looking for a simple answer to guide my elections on DMSH expense vs depreciation deduction. Did i just uncover a potential downfall of DMSH expensing for individuals in the 28%+ tax bracket? also others may want to know if it's still desirable incase you're in the 20% tax bracket.