Home Improvements and Rental Real Estate Sales or Exchanges

This column, in slightly different format, originally appeared in The San Francisco Examiner Newspaper, September 6, 1998

Copyright 1998 Robert L. Sommers, all rights reserved.

Question: Question: May I deduct improvements made to my residence?

Answer: Yes, but not until you sell it. Improvements are added to your "adjusted basis." When you sell your home, your gain equals the difference between the amount realized and your adjusted basis; therefore, your improvements lower your gain. A loss, however, is not deductible.

Your adjusted basis is usually the cost of your home, plus improvements and less any depreciation. Note: If you acquired your residence under the old rollover rules (Code Section 1034), your basis in the old residence carries over to your new residence. If you acquired your residence by gift, the donor's (giver's) basis becomes yours.

If you own and occupy your residence for at least two of the five years prior to sale, you may exclude $250,000 of profit ($500,000 for joint filers) under the new residency exclusion. Thus, unless your gain exceeds the residency exclusion, most likely in an inflationary real estate market or when held long-term, adding home improvements to the adjusted basis will not benefit you.

Example: Assume your adjusted basis is $200,000 with home improvements of $60,000. Your new adjusted basis becomes $260,000. If you sell your home for $450,000, your gain would be $190,000. Without the improvements, your gain would be $250,000 ($450,000 less $200,000 adjusted basis). In either case, the residency exclusion will eliminate any tax on your gain. Since you will not know whether you will need deductions until your residence is sold, it's wise to retain your home improvement receipts.

Question: As a U.K citizen living in the U.S. who owns U.K. rental property, how can I minimize or avoid U.S. capital gains tax if I sell it?

Answer: Because your property is located in a foreign country, you cannot use the tax-free exchange provisions (Code Section 1031) to exchange your property for U.S. property. However, the residency exclusion will apply if you owned and lived in the foreign property at least two of the past five years prior to its sale.

Otherwise, if you plan to return to the U.K., consider selling the property on an installment basis to defer the gain until you are a U.K. resident. That way, you will not owe U.S. taxes on the sale. Also, consider borrowing against the property and investing in U.S. property with those proceeds. When you return to the U.K., you can sell the U.K. property and repay the U.K. loan without paying U.S. taxes. In addition, an exchange of your U.K. property for other foreign real property held for investment is permitted under Code Section 1031.

Question: I bought a residential condo as an investment for $48,000, then sold it for $70,000. My profit was $22,000 but I depreciated it $39,000 over the past 13 years. What is my taxable gain?

Answer: Your gain is $61,000, calculated as follows: The amount realized ($70,000) less your adjusted basis of $9,000 ($48,000 less $39,000 = $9,000). Assuming you are above the 15% tax bracket and have owned this property at least 12 months, you are taxed as follows: The $39,000 attributable to depreciation is taxed at 25% federal; the $22,000 balance is taxed at 20% federal. California taxes your $61,000 gain as ordinary income.

Question: I purchased a single-family dwelling for $300,000, and have added two apartments which has increased the structure's current value by $250,000. Am I eligible for the residency exclusion for the apartments?

Answer: No. You cannot use the residency exclusion for the rental portion of your dwelling, but the tax-free exchange provisions (Code Section 1031) will apply to the rental portion. Thus, you can combine the residency exclusion with the tax-free exchange provisions to eliminate taxes at the time of the sale.

Example: Assume your dwelling sells for $750,000, has a $300,000 adjusted basis, you use one-third as your residence and you have not depreciated the residence. The residence portion is worth $250,000 with a $100,000 adjusted basis (1/3 the total) while the rental portion is worth $500,000 with a $200,000 adjusted basis. You exchange the rental portion for investment property and receive cash of $250,000 for the residential portion. The new residency exclusion eliminates tax on the $150,000 of gain ($250,000 less $100,000 adjusted basis). The investment property received in the exchange will have a carryover basis of $200,000.

In contrast, if you sold the dwelling for cash, you'd have a $300,000 gain on the investment portion of the dwelling. Gain attributed to depreciation is taxed at 25% federal, and the gain balance is taxed at 20% federal. California taxes the entire gain at ordinary income rates.


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**NOTE: The information contained at this site is for educational purposes only and is not intended for any particular person or circumstance. A competent tax professional should always be consulted before utilizing any of the information contained at this site.**