Landlord Tenant Q&A with LAURENE H. YOUNG, (B)
Q. I prepare my own taxes and I sold my rental property last year after owning it for 17 years. I was talking to a friend who mentioned in reporting my gain for tax purposes I needed to use my basis and not the original sales price. What is that? Was there something I should have been doing all these 17 years?
A. First of all, I am not a tax professional, so I would highly suggest that you discuss your specific tax situation with someone who is more qualified to advise you. Though I am discussing the most commonly used way to depreciate your property, there are other methods that could be used.
Your friend is correct.
The “basis” is what your property is worth for tax purposes and changes over time. The original basis could be determined by what you paid for the property, including certain other expenses like sales tax and certain fees charged, or the value of the property when you inherited it. If the property was acquired in a Section 1031 exchange, then you will need to check your return for the year of the exchange to determine the “deferred basis” (any capital gain that was not claimed at the time of the exchange). Things that can change your basis include certain improvements made to the property that have a useful life of more than one year, damages due to floods or fire not covered by insurance, and depreciation of your rental property.
Currently, most taxpayers are allowed to depreciate their rental property over 27.5 years (this may have changed from 17 years ago). Depreciation is calculated on the value of the property and excludes the value of the land. Assuming you kept the property for 27.5 years and depreciated it every year by the depreciation allowed, at the end of 27.5 years your only remaining basis would be the value of the land. Each year, for 27.5 years, your tax liability is reduced because you are allowed to deduct the depreciation of your property from the rental income you earned. Note that any appliances you purchase for the rental property cannot be deducted in its entirety in the year it was purchased, but must be depreciated over time (typically over 5 years).
Now that you are selling the property, you are required to pay income tax based on the profit. Your profit is determined by taking the selling price (including certain selling expenses), subtracting the original basis and adding back the depreciation taken or allowed to be taken.
Your adjusted basis in the property will have decreased over the years that you rented it out. Even if you did not claim all the depreciation you were entitled to deduct, you must still reduce your basis in the property by the full amount of depreciation that you could have deducted. In other words, your basis will be decreased even if you neglected to take the deduction. You would have paid more in taxes all those years because you did not take the depreciation to offset part of your income. The taxes when you sell your rental property will be the same whether you had taken the depreciation or not.
If you did not take the depreciation, you can amend your returns for the previous three years to claim the depreciation for those years. Any years prior to the three year period cannot be amended to claim the depreciation not taken. If you have any questions, you should obtain the services of a tax professional to review your returns and to help you correct any errors.