Cost basis of owner-occupied duplex with improvements

14 Replies

Hello, I am trying to confirm how the IRS requires me to calculate the cost basis of an owner-occupied duplex for calculating my capital gains. I think I know the answer, but I am also hoping I am wrong because it doesn't seem fair. I sold an owner-occupied property for which I had for about 10 years and made a majority of the improvements to my unit and rented the other unit for basically the entire time I owned it. I imagine this is pretty common.

Publication 523 lays out the method to figure out my gain on the rental use of the home. As a duplex, each unit was completely separate and not connected. My question really only involves how to divide up the improvements to increase my cost basis. On the owner side, I am exempt from capital gains because I will not go above my 250/500K limit.

For the improvements done only to my owner-occupied unit, am I only allowed to add those to the personal (home) side of my cost basis? This seems straight forward at first, but to me, it seems a little unfair when I calculate the cost basis of the rental portion. Obviously the sale price of the property is one number, and not divided up to the relative value of each unit. 

For example, If I sold the property for 500K, and my square footage was 60% owner-occupied, and 40% rental, then my rental portion sale price is 200K. But say I poured 100K in improvements into my unit, then you would expect that I would recapture some of those improvements in the final sale price, so it seems unfair to me that I can only deduct 100K to the proportion of the personal side sale price in calculating my gain. Had I not put the 100K in improvements into the property, my overall sale price would have been lower, and thus the proportion of the sale price for the rental unit would be less (and hence less capital gains). 

Does anyone know if I can apply some other method to calculate my capital gains on the rental portion?

Zeek

Did you expense the improvements made specifically attributable to the rental portion when you reported your rental income on that portion of the property, or did you capitalize those costs and depreciate them?

Originally posted by @Christopher Smith :

Did you expense the improvements made specifically attributable to the rental portion when you reported your rental income on that portion of the property, or did you capitalize those costs and depreciate them?

To answer your question, any major improvements specifically on the rental unit were depreciated. I am aware I need to recapture the depreciation for those improvements (a decrease to the cost basis), and that I can also add the cost of those improvements to the cost basis of the rental unit. 

 Back to my original question, it just seems like a better, or at least a more fair method, would be if the IRS allowed me to apply the total cost of all major improvements (no matter which unit) against the sale price, before proportioning out the profit to each side. Let me list a couple examples that will clarify:

Cost of duplex: 100K,  Sale price: 500K, 100K improvements on owners side which has 60% of total square footage of the house, 25K depreciated on rental side.  This results in a total gain for the rental side of  (500K-100K)x40% + 25K = 185K. Gain for owner side (500K-100K)x60% - 100K = 140K

OR, if allowed, a more logical method would be: (500K-100K-100K)x40% + 25K = 145K. Owners side: (500K-100K-100K)x60% = 180K. 

It just doesn't seem fair to be only able to apply major improvements to one side's cost basis or the other, when in the end there is one sale price, and it impossible to know how the improvements effected that sale price in the end. 

Ok I see a little more clearly what the facts are now. Maybe you can make the case that there is a class of improvements that were in effect common improvements that benefit the property as a whole. This notwithstanding the fact that they might otherwise be seen as more associated with one side than the other.

It kind of sounds a little like a tax result driven determination which could be seen as reaching by an auditor. In any event, at its essence its a highly factual call so I'm not sure you're going to find much on point for comparative purposes without some real digging, and then maybe not even then.

If it were me I'd just make a risk assessment determination and then be prepared to defend my position on audit if I made the call to go forward with that treatment. 

@Kurt Zarwell No, you have it right....and it is completely fair. It is just like having 2 separate properties....one owner occupied and one investment property. If you had spent $50 k on the Investment side, wouldn’t you want to be able to add All of that to your cost basis?  Not sure why you think your idea is more “fair”.

Just a post script, publications aren't law, so while you should be prepared to defend yourself if you take a position contrary to something in them, you're not per se bound by them.

Originally posted by @Wayne Brooks :

@Kurt Zarwell No, you have it right....and it is completely fair. It is just like having 2 separate properties....one owner occupied and one investment property. If you had spent $50 k on the Investment side, wouldn’t you want to be able to add All of that to your cost basis?  Not sure why you think your idea is more “fair”.

I think his position is perhaps a little more nuanced than that.

Originally posted by @Christopher Smith :

If it were me I'd just make a risk assessment determination and then be prepared to defend my position on audit if I made the call to go forward with that treatment. 

Christopher, thank you for your reply and great advice. I have searched and searched for any guidance on this situation other than what is in publication 527, and have come up nearly empty. 

 

Originally posted by @Wayne Brooks :

@Kurt Zarwell No, you have it right....and it is completely fair. It is just like having 2 separate properties....one owner occupied and one investment property. If you had spent $50 k on the Investment side, wouldn’t you want to be able to add All of that to your cost basis?  Not sure why you think your idea is more “fair”.

When you make improvements on a duplex, you increase the value of the entire property because there is one sale price. Why they make you split up your improvement costs doesn't seem logical to me. 

 

Ignore for a moment the tax benefit your receiving for owning the home as a primary residence. At the end of that scenario you would owe $Xx,xxx amount of tax regardless of split.

The government gave you a benefit to exclude a portion of your primary residence. You just want to allocate more gain to the tax free portion. I understand why, but if you ignore the tax benefit your receiving, there is nothing unfair in the governments allocation and I doubt you would care which side the improvements were credited to if there was no tax benefit.


@Kurt Zarwell

Sorry for the delay answering your question. I was too busy laughing at your persistent use of the word "fair" while talking about... taxes, of all things!  :)  

I recommend you follow the excellent advice of @Wayne Brooks : treat your duplex as two properties. Fortunately, you get to allocate both the purchase price AND the sale price using any "reasonable" method, and it will somewhat lessen the tax impact that you fear.

Let's say that the duplex was initially purchased for $200k, and the units were in the same condition. You then allocate $120k (60%) to your personal unit and $80k to the rental. Over 10 years, you added $100k of improvements to your personal unit, so your tax basis in your residence is now $220k. Over the same 10 years, you depreciated $20k of your rental unit, so your tax basis in the rental is now $60k.

Now you're selling the duplex for $500k. However, the units are no longer comparable. Your side is a brand new shining shrine, while the rental remains the dump it was originally, because you neglected it for 10 years - which is unfair, by the way ;). Based either on an appraisal (best) or on your Realtor's opinion (2nd best) or on your own guess (not really the best) - you now allocate $400k of the $500k sales price to your residence, and the remaining $100k to the rental.

Result:

Residence: Capital gain = $400k - $220k = $180k, all excluded from taxation.

Rental: Capital gain = $100k - $60k = $40k, of which $20k is long-term capital gain, and the other $20k is depreciation recapture.

Of course, I over-simplified my example by ignoring complexities of depreciation, improvements to the rental side, closing costs and a number of other factors. But it should give you a general idea.

@Michael Plaks

Thank you for that explanation! I was not aware I could aware allocate/proportion the sale price using any other method besides a percentage of the square footage. I will go back and take a look at the appraisal and see if there are any clues as to how I could do that. Is that commonly done? 

One other question that popped up regarding improvements. Can you use minor improvements, such as new window blinds (there weren't any) to increase the cost basis if I expensed/deducted those improvements in the year they were purchased? Seems like that answer would be no, otherwise it would be double dipping. 

Thank you!

One other question that popped up regarding improvements. Can you use minor improvements, such as new window blinds (there weren't any) to increase the cost basis if I expensed/deducted those improvements in the year they were purchased? Seems like that answer would be no, otherwise it would be double dipping. 

I think I answered this question... if it was expensed and deducted, then no, it is not a capital improvement. 

 

Originally posted by @Kurt Zarwell :

Can you use minor improvements, such as new window blinds (there weren't any) to increase the cost basis if I expensed/deducted those improvements in the year they were purchased? Seems like that answer would be no, otherwise it would be double dipping. 

I think I answered this question... if it was expensed and deducted, then no, it is not a capital improvement. 

You sure did :)