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Rental Taken out of Service To Sell

Technical topics regarding tax preparation.
#1
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Client took rental out of service in May 2015 to do some upgrades and then sell. The property did not sell until late 2016 due to a bad market. I just want to make sure that I am reporting the Rental correctly in 2015. Here is what I think I should be doing.

Stop depreciating the property as of date out of service.
Allocate R/E taxes between in service and out of service periods and put out of service on Schedule A.
Allocate Mort Int between in service and out of service periods and put out of service on Schedule A (Investment Interest, Not Home Mortgage Interest)
All other rental deductions deduct for in service period and then ignore for out of service period.

Is that right?
 

#2
WEISSEA  
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"Is that right?"
Yes, Pub 527: Vacant while listed for sale.   If you sell property you held for rental purposes, you can deduct the ordinary and necessary expenses for managing, conserving, or maintaining the property until it is sold. If the property is not held out and available for rent while listed for sale, the expenses are not deductible rental expenses.
 

#3
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If the nature of the "upgrades" is more like a renovation or some big kinda project, you may find that some of the expenses during the upgrade may be able to be capitalized into the tax cost of the upgraded stuff. I forget where it is, but it's IRS's regulations somewhere that "requires" this. Not really sure what the requirements are, but if you find the section on "capitalized repairs" maybe that's where it can be found. Or maybe it's the section on "period of reconstruction."
 

#4
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Thanks. the upgrades were major improvements (bathroom renovation and new flooring) so I will just add those to basis in the sale calculation.
 

#5
Coddington  
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Y'know, Harry, the one thing that has always bothered me about this issue is whether the rental is in a trade or business. If it is, then the treatment is different from the above and it wouldn't stop depreciating, etc. But if it is merely held for the production of income, then stuff happens under 212.
-Brian
Tax accounting methods and credits consultant for hire.

http://www.coddingtontax.com
 

#6
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Section 167 seems not to discriminate between "used in the trade or business" and "held for production of income":

"IRC § 167(a):
General rule
There shall be allowed as a depreciation deduction a reasonable allowance for the exhaustion, wear and tear (including a reasonable allowance for obsolescence)—
(1) of property used in the trade or business, or
(2) of property held for the production of income."


If you happen to stumble on a definition of "trade or business" please let us know... 8-) 8-) 8-)
 

#7
Coddington  
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That's one of those weird things. Section 167 doesn't discriminate and the case law makes very clear that an asset used in a trade or business keeps depreciating until disposed of or converted to personal use. Why the same rule doesn't apply to rentals held solely for the production of income I do not know.
-Brian
Tax accounting methods and credits consultant for hire.

http://www.coddingtontax.com
 

#8
Noobie  
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If they are looking to make a gain on the sale, who cares about the depreciation?
 

#9
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What about 1231 gain vs dealer? I would want to make sure that the propery was still a rental asset to preserve 1231 gain. The extent and nature of the renovations along with sales effort could taint this to be dealer property. You see something similar to this argument in the condo conversion world.
 

#10
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Noobie wrote:If they are looking to make a gain on the sale, who cares about the depreciation?


Depreciation = deduction against ordinary income

Gain on sale = Likely LTCG

Seems like something to care about to me.
~Captcook
 

#11
Chay  
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Coddington wrote:Y'know, Harry, the one thing that has always bothered me about this issue is whether the rental is in a trade or business. If it is, then the treatment is different from the above and it wouldn't stop depreciating, etc. But if it is merely held for the production of income, then stuff happens under 212.

Let's say the rental is a trade or business that consists entirely of holding out a single property for rent. If you take that property off of the market with the intention to sell it, and then follow through, doesn't that mean the trade or business was over at the time the property was taken off the market? And doesn't that mean there is no longer a case for any further business deductions, since there is no longer any income expected?
 

#12
Chay  
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In trying to answer my own question, I've located Lenington v. Commissioner (T.C. Memo. 1966-264). In this case, the court answered the question "[c]an petitioners deduct depreciation on poultry buildings after they ceased operating their poultry business but while the buildings were for sale?" in the affirmative. The court reasoned as follows:

    Since the poultry buildings were not abandoned or converted to personal use prior to 1962, but were involved in a discontinuance of the active conduct of the poultry business, their previously established character as business property was not changed.
Can we conclude from the court's opinion that an effort to sell the assets formerly used in a business is a continuation of the business activity itself? Is this true even if the taxpayer has no intention to resume operations in the event that the sale is unsuccessful? What about the expenses of maintaining the business assets held for sale?
 

#13
TrueTax  
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It is surprising that the guidance for such a common situation is not more clear.

I have a client who took a rental out of service that likely will not be treated as a trade or business and then subsequently sold it. As Chay and Brian Coddington have pointed out, there is authority for continuing to depreciate property used in a trade or business and Brian added the following observation above:

Coddington wrote:That's one of those weird things. Section 167 doesn't discriminate and the case law makes very clear that an asset used in a trade or business keeps depreciating until disposed of or converted to personal use. Why the same rule doesn't apply to rentals held solely for the production of income I do not know.


It looks to me like the difference between a trade or business deduction for depreciation and a deduction for depreciation or other expenses related to rental property that is not a trade or business is that the former is allowed as a deduction by IRC 62(a)(1), but the latter must pass through IRC 62(a)(4).

IRC Section 62(a)(4) allows the following:

The deductions allowed by part VI (Sec. 161 and following), by section 212 (relating to expenses for production of income), and by section 611 (relating to depletion) which are attributable to property held for the production of rents or royalties.


Although Section 167 does not discriminate between property held in a trade or business or held for the production of income, Section 62(a)(4) above attaches the additional condition that the deduction must be "attributable to property held of the production of rents or royalties" in order for the Section 212 amount to be deductible against AGI.

One could argue that property that was at any time in the past "held for the production of rents or royalties" would fall under a literal reading of this section, and therefore the deduction of costs after the property is taken of the rental market and listed for sale should be allowed, but the legislative history construes the meaning of this section narrowly:

The deductions described in clause (1) above are limited to those which fall within the category of expenses directly incurred in the carrying on of a trade or business. The connection contemplated by the statute is a direct one rather than a remote one. for example, property taxes paid or incurred on real property used in the trade or business will be deductible, whereas state income taxes, incurred on business profits, would clearly not be deductible for the purpose of computing adjusted gross income. Similarly, with respect to the deductions described in clause (4), the term “attributable” shall be taken in its restricted sense; only such deductions as are, in the accounting sense, deemed to be expenses directly incurred in the rental of property or in the production of royalties. *** (S. REPT. 885, 1944 C.B. AT 877-878)


This language was relied upon by the court in applying this section in the Strange case which dealt with whether an income tax levied upon royalty income was deductible under IRC 62(a)(4), as follows:

The language and structure of section 62(a) reveal Congress's intent that state income taxes levied on net royalty income (gross royalty minus production taxes, overhead, operating expenses, and depletion) are not deductible above-the-line. Such income taxes are not expenses incurred in the production of the royalty. See Accountants' Cost Handbook, 1.9 (James Bulloch et al. eds., 3d ed. 1983) (defining expenses as “expired costs ...used to produce revenue”). Above-the-line deductions must be attributable to “property held for the production of ...royalties” — not attributable to the royalties derived therefrom. I.R.C. section 62(a)(4) (emphasis added). The language and sentence structure plainly divide the “property” from the derived “royalties.”


So if the costs deductible under 62(a)(4) for a rental that is not a trade or business must be "expired costs ...used to produce revenue," and must be "expenses directly incurred in the rental of property or in the production of royalties," then it seems that a more stringent standard may exist for these costs than for trade or business costs and that the IRS position in Publication 527 quoted above may have some weight.

This is not the conclusion I wanted to come to, so hopefully someone will be able to point out a flaw in this analysis.
 

#14
Chay  
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TrueTax, I agree with your conclusion. I'd also like to add is that although your client can't benefit from any depreciation, the house isn't actually retired from service for depreciation services. If we still had 2% miscellaneous deductions, that's where the depreciation would show up along with any "expired costs used to produce revenue". Because we don't, the depreciation attributable to the time after which the house is no longer "property held for the production of rents" is disallowed. I would take the depreciation expense for a full year and prorate it by the number of days in the year that the property was held for rents to get the depreciation expense for that year.

When Congress decided to allow deductions above the line for rents, royalties, and capital losses, they were trying to make the various types of income "as nearly equivalent as practicable" to other types of income, such as interest and dividends, for the purpose of "equitable application of a mechanical tax table or a standard deduction" (S. Rept. 885, 1944). Expenses for the maintenance of tangible property employed in a productive use are to be expected; not so with intangible property like stocks and bonds. I think this is the reason why Congress would view the expenses incurred when the property is no longer held for rent in the same light as portfolio management expenses.
 

#15
dave829  
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Chay wrote:Can we conclude from the court's opinion that an effort to sell the assets formerly used in a business is a continuation of the business activity itself? Is this true even if the taxpayer has no intention to resume operations in the event that the sale is unsuccessful? What about the expenses of maintaining the business assets held for sale?

You might want to look at Carter-Colton Cigar Co., 9 T.C. 219 (1947).
 


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