Business transactions must always be analyzed to understand first, the income tax consequences of the transaction and second, the reporting of the transaction. This brief article attempts to address a not so uncommon disposition of a residential rental property. The outcome, however, as presented in the fact pattern, results in what may be for some a counter-intuitive result.
Note: It is assumed without discussion that the rental activity in this example rises to the level of a trade or business. The article is not intended to suggest that all such rentals will be trades or businesses. That is a discussion for another day.
George and Margaret purchased a residential property for $200,000 with the intent to rent the home to tenants. The purchase closed on July 1, 2010, and the property was immediately placed into service with the renters who occupied the property.
Allocations to basis were made: $30,000 to the lot (not depreciable) and $5,000 to personal property: washer, dryer, stove, etc. The remaining balance was assigned to the residential building at $165,000. The personal property was depreciated over a five-year recovery period with a resulting basis of zero in 2016. Straight-line depreciation was taken on the house, using a mid-month convention which resulted in $500 per-month depreciation. [($165,000 / 27.5 years) / 12 months/year]
In 2016, the refrigerator, washer, and dryer were replaced at a cost of $800 each. Fifty percent bonus depreciation was used and the remaining cost was depreciated over a five-year recovery period, half-year convention, 200 percent declining balance.
In 2020, George and Margaret sold the rental property for $375,000 on June 30, 2020. During the ten-year period of ownership, the land value had appreciated significantly, as compared to the rental house value. The area of town in which the property was located was attracting many new residents wishing to build, and the house may have been viewed as a “knock-down.” Based on the appraiser’s report, which approximated FMV, the lot value was estimated to be $300,000, the house was valued at $74,500 and the appliances were worth $500. The remaining adjusted basis in the house was $105,000. [$165,000 – ($500 / month x 120 months)] At the time of the sale, the remaining adjusted basis of the refrigerator, washer and dryer was $45.20 for each. [$400 * 0.8842] As a result, George and Margaret faced a loss on disposition of the house, but a gain from the overall transaction.
The Tax Issues to Consider
The story above describes a not too uncommon disposition of a business property with several different pieces of property that may result in gains or losses. However, these facts may make the reporting of this disposition somewhat interesting. The lot is IRC § 1231 business property, the house is IRC § 1250 property, and the appliances are IRC § 1245 property. The sale of the house results in a loss. However, the disposition of the combined assets results in a gain. Below is a completed IRS Form 4797, Sales of Business Property, for this sale.
The disposition of the house is reported on Part 1 of Form 4797, and a net § 1231 gain results. If the house had been sold for a gain, the disposition would have been reported on page 2, Part III, lines 19 and 26.
The allocation of $500 to the appliances generates a gain of $364.41, which is the depreciation recapture on the IRC § 1245 assets as shown in Part III Lines 19-25.
As a practical matter, the appliances might be listed as a group of assets, which ultimately report the same total result of IRC § 1245 recapture of $364.41.
An alternative, which is alluded to in the story, is that the house is indeed to be a “knock-down” and thus, the purchase price reflects the lot price. If this is the case, then, the house has no value to the purchaser, nor do the appliances. It might be possible to report the sale as a “sale of the lot only,” knowing that the improvements and any personal property was going to be either bulldozed or taken to the white goods recycle center by the purchaser. If this were the case, then the seller, might report $135.60 as a loss on Part II of Form 4797 as the recovery of remaining basis of the appliances.
This is not an unusual situation regarding a disposition of rental property and provides encouragement for the income tax professional to fully understand the fact pattern and “peel the onion,” so to speak. All the pieces of the transaction need to be considered independently to separate all the pertinent details so that correct and accurate reporting of the disposition is accomplished.