Determining Cost Basis for Rental Property That Was Single Family Home?

Question

How do I do about figuring the cost basis for rental property that used to be a single family home. My wife and her ex husband bought the place in 1995 and lived there until 2000. They divorced and she got the house. We got married and began renting the house in 2001. How / where can I find information about figuring the cost basis when it began as a rental. We are selling the unit next week and the selling price is 120K more than they originally paid in 1995 so I was trying to get information on how to treat the taxes. I know capital gains are going to kill us, but we just put over 20K in the house repairing damage from the prior tenant who cannot be located. Need to know about how much to keep back to cover the tax liability before we invest the rest. Thanks

Answer 1

Although I am not a tax expert, it is my understanding that the first $250,000 of profit is not subject to capital gains.

Answer 2

The cost basis is whatever she and her ex paid for it plus the cost of any improvements. (The damage repairs are not considered improvements, by the way, though they may be deductible as an expense against the rental income for the year that they were incurred.) Then you must reduce the cost basis for any depreciation allowed or allowable for the time it was used as a rental. If you took depreciation expenses (or could have taken them but did not!) of $20k since you converted it to a rental you must reduce the cost by that 20k.

Here's a quick example:

Purchase Price in 1995: $100k
New heating system, 1998: $4k
Cost Basis: $104k
Depreciation allowed or allowable as rental: $20k
Adjusted Cost Basis: $84k

Net Sales Price: $220k

Taxable Gain: $220k - $84k = $136k

The gain of $136k in this example is treated as a long-term capital gain since you owned it for over 1 year and is usually taxed at 15%. The tax would therefore be $20,400.00

(The realtor above is right about one thing: She's no tax expert. To exclude the gain from taxes you would have to live in the home as your principal residence for 2 of the 5 years immediately prior to the sale. The exclusion would be $500k if you were eligible since you are married filing jointly. If you did meet the residency requirements for the exclusion, the depreciation re-capture I outlined above would STILL apply and that portion of the gain would be taxable as a long-term CG.)

Answer 3

In my opinion (based on my experience), rental costs will slide downwards slowly. Therefore you should enter into 6 to 12 months rental agreements only. Nothing longer. Depending on how long this sub-prime issue drags on, your long term plan really should be to purchase a small home (or something you can afford) to start with. Urban areas in California will be the first to rebound once the crisis blows over.