How to determine cost basis? Help!

Question

My husband and I have just sold our longtime home in Michigan. We moved to Tennessee in 2008 and have been renting it out for the past 7 years.  Here are the basics: We bought it for 130K 20 years ago and just sold it for $425K. After the dust settles, we plan on buying a small rental here in TN. We researched the 1031 Exchange but didn't feel it would meet our needs. So we are planning for a hefty capital gains tax bill next year.

Our accountant has explained to us that in order to figure out what we owe in taxes, we need to figure out the cost basis for the Michigan house -- adding up all the major improvements we did while we lived there (roof, kitchen, two bathrooms, turning a garage into a studio, etc.)

He seemed to think that the IRS will NOT question us about these improvements or ask for proof, receipts, etc. -- that you can basically come up with a figure. Is this true? We certainly do not have any kind of accurate paper trail for all the stuff we did to that house over all those years.

Obviously, we want the cost basis to be as high as possible, reflecting the work we did. How do others handle this situation?

Is there any other aspect of mitigating the tax that we might have overlooked? THANKS!

Dave Foster · Answer

It seems like a missed opportunity for additional depreciation doesn't it @Brandon Hall?  I would think the CPA would have adjusted the cost basis when placing the property in service on the Sched E and added in capitalized expenses at that point.

@Wayne Brooks, my guess is the answer to why not the 1031 was that they anticipated a "small" rental in TN so the buy down and boot may have offset any deferral from the 1031.

Wayne Brooks · Answer

Agrred, howm the heck is he deducting depreciation without first having a cost basis?  Since it's been a rental for 8 years, I'm thinking a 1031 was Definitely the way to go.

Dave Toelkes · Answer

Technically, the initial tax basis for the rental property was the fair market value of the property on the date it was converted to a rental, or, your actual cost basis whichever was less.  Your accountant at the time of the conversion to rental use should have helped you determine your actual cost basis, as well as, asked you to get an appraisal.  If my memory is correct, 2007 was when the real estate bubble burst and in 2008 property values in many US markets had fallen dramatically.

It may be possible that in 2008 when you converted to a rental, the appraised value of the property would have been less than your adjusted cost basis.  In this case, the appraised value would have become your tax basis for depreciation and for calculating your capital gain on a future sale of the rental property.

Suggest you contact a licensed appraiser, local to the area where your rental property is located, and ask for a retrospective appraisal for the date of your conversion.  Professional appraisers have the software to do this and the cost should be about the same as a current appraisal.

if there has been no depreciation taken on the property during your holding period, ask your new accountant to help you prepare IRS Form 3115.  Form 3115 can be used to bring your depreciation up to date ("catch up") and is filed with your annual tax return.

David Krulac · Answer

@Daniel Chang

I don't think that it is a mistake to turn a personal residence into a rental property.  Au contare, I think that it is a good idea.

You already know the house and have worked out any bugs.

You like the house.

Somebody else will probably like the house.

You have made improvements and upgrades to the house.

The mistake is not keeping good records.  For both state and Federal tax purposes, depending on your state, you should keep all tax relevant documents, like bills, taxes, insurance, and all expenditure and improvement for at least 7 years AFTER you sell the property.  We've had the IRS ask for documentation for properties sold 20 years ago!

Daniel Chang · Answer

@Whit Hill

What he's saying is that the liklihood of an IRS is low.  But IF you get audited, you will need more proof that a random guesstimate of how much capital improvements you've made over the years.

(I'm saying the following more for the BP community, not to harp on your situation).

I think one of the most common and yet biggest mistake people make is that they rent out their personal residence after they've lived in it.  The IRS already offers capital gain exclusion of up to $500K for married filing jointly.  You can rent it out for up to 3 years and still qualify for the exclusion.  Essentially, for most people this will cover any capital gains in the sale of the primary residence (forget the 1031!).

The only question is right after you move out, in those 3 years, do you think the house will appreciate where the capital gain component is >15% (not the whole house, but just the capital gain component).   Gaining 15% only puts you at net even!  Even if you think the house will appreciate (capital gain component) say 25%, of which you pay 15% in federal tax leaving a net of 10%....this is still a pretty bad investment (IRR of 3.22%).

Better to just take your capital gain tax free and invest that money elsewhere.

David Krulac · Answer

@Whit Hill

If you are audited, you will need receipts, cancelled checks, names of contractors, (did you 1099 them?) photographs and any other evidence that you have or can get.

And then the IRS can disallow your claims due to lack of convincing documentation and you'll owe some taxes.  Its not criminal, unless you lie, and so you're not going to jail.

Your accountant would have needed to calculate the cost basis when you converted to rental just to figure out the depreciation.  and if your accountant failed to take depreciation, its lost forever, as the IRS code says, "depreciation taken or allowed".  If you were allowed to take depreciation and didn't you lose.  If the accountant failed to take depreciation at all, which you can see on line 18 of your Schedule E tax return, you might want to fire the accountant and sue them against their Error and Omission Insurance.

Whit Hill · Answer

To be clear, I think the cost basis he (and our Michigan tax man before him) have used was the purchase price of the house back in the mid-'90s.

Re establishing a paper trail, I think we probably could reconstruct it as we personally know nearly all the workmen who did the work.

Whit Hill · Answer

Thanks all. In answer to why not the 1031, you are right: as I understand it, we would have had to buy a like property here in Nashville -- around 425K -- which would have meant a hefty mortgage which I'm not sure we'd qualify for currently.

Maybe it was a mistake not to try, but the situation is complicated (too much to go into here) and we just decided to pay the tax.

After we pay down some debt and pay the tax, we'll have maybe 60K that we can sink into a modest rental. There are lots of homes in the $120K range and I think we'll be able to get  small mortgage. Fingers xd.

I admit I'm totally confused by the cost basis thing and why our accountant here (who is also a real estate agent) didn't figure that in when we started going to him (the same year we turned out MI house into a rental).

Not sure what to do now, but maybe I should get a second opinion on things.

Brandon Hall · Answer

@Whit Hill

Seems like you may have a case of an accountant who isn't real estate savvy. If he's been calculating depreciation, he should know the cost basis of the property. So something isn't adding up here.

You'll want to have invoices, work provided, costs incurred, vendor names (contractor names), etc. Basically you can't just come up with a random number and call it a day, you need to be able to support it, preferably with a source document.

You should consider seeking out another accountant (RE savvy) to review your documentation and provide you with a second opinion and tailored support.

Whit Hill · Answer

I'm pretty sure our tax accountant has been calculating depreciation all along. He too seemed surprised that a cost basis hadn't been calculated years ago. Wasn't that something he would have known to do?

If we were ever audited, what would be needed? Names of workers? Cancelled checks, etc.?

We went through a terrible flood here in Nashville in 2010 and lots of paoerwork was lost. We have lots of stuff on Quicken tho. Maybe that would count?

Thanks for your response. Helps us know what questions to ask our accountant.

How to determine cost basis? Help!

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