 Income tax 2022-2023, rental property, special situation, condominiums, corporatives, and property changed to rental use. Let's do some wealth preservation with some tax preparation. Most of this information comes from publication 527 Residential Rental Property including rental of vacation homes tax year 2022 you can find on the IRS website irs.gov irs.gov looking at the income tax formula we're focused on line one income remembering the first half of the income tax formula is in essence an income statement but just an outline other forms and schedules flowing into these line items one of those the schedule E in essence an income statement in and of itself rental income minus rental expenses the net rental income flowing into line one income of the income tax formula with rental real estate income as with business income we typically want to keep it separate from our personal activities which helps us with our bookkeeping it helps us with our planning and budgeting into the future and of course it helps us with our tax preparation so in prior presentations we've been focusing in on scenarios where we have a separate piece of property used 100 support accounting 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situation where we live in a unit or live in a place but we rent part of it out now we have to be parsing out between business and personal we also could have situations where we have like common areas that we'll talk about okay so first let's take a look at the condominiums so a condominium is most often a dwelling unit and a multi-unit building but can also take take other forms such as Hound House or garden apartment so now you've got this unit that's in a building you own it you're not renting the unit but you own the unit in the building so if you own a condominium you also own a share of the common elements such as land lobbies elevator and service areas so obviously if you think about a building you own a nice place in the condominium but you have to get up there to get to the place you've got the elevator you've got all the common areas related to the condominium those are owned in part by the owners of the condominium so now you've got this kind of community kind of situation that is owning these common areas and then of course you own the unit exclusively so you and the other condominium owners may pay dues or assessments to a special corporation that is organized to take care of the common elements and now you've got this little political unit that's designed for the purpose of taking care of those common areas which everybody of course disagrees on how to do but in any case special rules apply if you rent your condominium to others so you can deduct as rental expenses all the expenses discussed in chapter 1 and 2 in addition you can deduct any dues or assessments paid for maintenance of the common elements which kind of makes sense right if you have the condominium you rent out the condominium well now you've got the expenses related to the condominium that are similar to other kinds of rental property but you also have these dues that are being paid which are basically required for the condominium so you would think you'd be able to deduct them as rental expenses you can't deduct special assessments you pay to a condominium management corporation for improvements however you may be able to recover your share of the cost of any improvement by taking depreciation corporatives if you live in a corporative you don't own your apartment instead a corporation owns the apartments and you are a tenant stockholder in the corporative housing corporation so it's a different structure of ownership which could have some benefits but has some complexities attached to it as well clearly it's a similar structure as we see in the business world with a corporation so we can compare like a partnership for example to a corporation if you have a partnership in a normal business setting the partners own the partnership directly their percentage ownership is determined by their capital accounts and the partnership agreement when we move to a corporation we think of the corporation as a separate legal entity which could lend some liability protection to the owners the shareholders of the corporation which is one reason to go to a corporation often times in a normal kind of business settings and then the ownership of the corporation is going to be broken out into fixed units of shares which make the shares easier to kind of transfer often times and then someone's ownership in the corporation will be dependent on the number of shares that are owned in it so you have a similar kind of structure here instead of valuing your particular unit or owning your particular unit and then having joint ownership of some kind to the common areas you would think you can imagine the whole thing as basically one corporation kind of situation and your ownership will be reflected by the number of tenant stockholders so once again if you live in a corporate you don't own your apartment directly instead a corporation owns the apartments corporations being a separate legal entity but it's just an entity and obviously you own part of the entity and you are a tenant stockholder in the corporate housing corporation so you own stocks that's going to be reflecting your value in the corporation ok so if you rent your apartment to others you can usually deduct as a rental expense all the maintenance fees you pay to the corporate housing corporation in addition to the maintenance fees paid to the corporate housing corporation you can deduct your direct payments for repairs, upkeep and other rental expenses including interest paid on a loan used by your stock in the corporation alright depreciation you will be depreciating your stock in the corporation rather than apartment itself this is where it gets kind of messy here it gets a little bit confusing because now you have the stocks that are representing which are in a corporation which are representing your property so you want to be able to get the depreciation clearly as an expense so you will be depreciating your stock in the corporation rather than the apartment itself figure your depreciation deduction as follows one figure the depreciation for all the depreciable real property owned by the corporation so we're going to think about it as a full unit first and then kind of think about our share of the depreciation right that would be based on our amount of ownership that we have okay so depreciation methods are discussed in chapter 2 so the corporative would be doing their depreciation thing if you bought your corporate stock after its first offering figure the depreciation basis of this property as follows a multiply your cost per share by the total number of outstanding shares b add to the amount figured in a any mortgage debt on the property on the on the date you bought the stock c subtract from the amount figured in b any mortgage debt that isn't for depreciable real property such as the part for the land because we can only depreciate the building to subtract from the amount figured in one any depreciation for space owned by the corporation that can be rented but can't be lived in by tenant stockholders three divide the number of your shares of stock by the total number of shares outstanding including any shares held by the corporation so now we're this is the ratio that we have now right because it's our number of shares compared to the total number of shares out there that's kind of our percent ownership you would think right so four multiply the result of two by the percent you figured in three this is your depreciation of the stock okay your depreciation deduction for the year can't be more than the part of your adjusted basis defined in chapter two so in the stock and your corporation that is applicable to your rental property payments added to capital account payments earmarked for a capital asset or improvement or others otherwise charged to the corporation's capital account are added to the basis of your stock in the corporation for example you can't deduct a payment used to pave a community parking lot install a new roof or pay the principal of the corporation's mortgage treat as a capital cost the amount you were assessed for capital items this can't be more than the amount by which your payments to the corporate corporation exceeded your share of the corporation's mortgage interest in real estate taxes so you can see where kind of the complexity comes into play because now you have to parse out the depreciation you have to kind of figure what that's going to be and then if there's improvements if you're paying for improvements in the building those again would usually be capitalized items that you would need to depreciate instead of expensing at the point in time that they happen so your share of interest in taxes and your share of interest in taxes is the amount the corporation elected to allocate to you if it be reasonable if it be reasonably reflects those expenses for your apartment otherwise figure your share in the following manner so now you've got the interest in taxes that the corporative itself might do a reasonable allocation to try to allocate the interest in taxes because now the corporation itself as the corporative like as a separate legal entity is going to be dealing with paying the interest in taxes for everything right and you get but you should be able to be deducting the part of the interest that's applicable to you and the taxes if you're renting your place in the corporative so now the question is well how do you figure out your portion well maybe the corporative itself will do that with some reasonable method if they do not then you got to calculate that one divide the number of your shares of stock by the total number of shares outstanding that gives us your percent interest in essence including any shares held by the corporation to multiply the corporations deductible interest by the number you figured in one this is your share of the interest so fairly straightforward calculation not too bad three multiply the corporations deductible taxes by the number you figured in one this is your share of taxes alright next situation we've got property that's changed to rental use so possibly it was personal in use and then we changed it to rental use so the so the issue there often becomes around the basis of the cost of the property because you bought it some time ago when you bought it you bought it at fair market value but now when you when you changed it to rental use then the fair market value could have changed for example and you got to deal with that depreciation situation again so if you change your home or other property or part of it to rental use at any time other than the beginning of your tax year you must divide yearly expenses such as taxes and insurance between rental use and personal use so now you've got this mid-year kind of problem because you changed from from personal to rental in the middle of the year so you can deduct as a rental expenses only the part of the expenses that is for the part of the year the property was used or held for rental purposes you can't deduct depreciation or insurance for the part of the year the property was held for personal use however you can include the home mortgage interest in real estate tax expenses for the part of the year the property was held for personal use when figuring the amount you can deduct on schedule A example so your tax year is the calendar year you moved from your home in May and started renting it out on June 1st you can deduct as rental expenses 712 of your yearly expenses such as taxes and insurance which makes sense because that's 712 is the ratio of 7 over 12 months right the year that you rented it starting with June you can deduct as rental expenses the amounts you pay for items generally build monthly such as utilities when figuring depreciation treat the property as placed in service on June 1st so now that would be like if we bought the property and placed it in service or something like that similar situation because that's when we put it into the rental side of things from personal side of things now we have the basis issue so it's like okay so now I know when to put it on the books what am I going to put it on the bookstore because I didn't just buy it basis of property changed to rental use when you change your property you held for personal use to rental use for example you rent your former home the basis for the depreciation will be the lesser of the fair market value or adjusted basis on the date of conversion now this makes sense if you think about it because let's say you bought the property a long time ago for $100,000 and now it's going up to $150,000 and you're converting it from personal property to rental property if you were able to just put it on the books at $150,000 the higher fair market value you would have gotten what we call a step up in basis which is a good thing usually you would like to be able to do that but notice what happens now is you didn't realize the gain of the $50,000 so usually if you sold the home for $150,000 and you cost $100,000 you'd have a $50,000 gain that might be exempted in that case if it was your personal residence but you have that gain situation and so you can't just wipe out the gain by saying well now I'm going to put it on the books at $150,000 and be able to depreciate and get $150,000 worth of depreciation or if I sell the rental property I've got this stepped up basis so the higher basis is usually good we want to have a higher basis and the IRS is going to be skeptical to step up the basis so that would kind of make sense. Okay fair market value FMV, this is the price at which the property would change hands between a willing buyer and a willing seller neither having to buy or sell and both having reasonable knowledge of all the relevant facts now this is a great idea in concept that we use all the time and it's quite difficult it's impossible to know because all property is unique this is real estate this isn't stocks that are the same so we can't really we don't know what that is that's the problem so if you allow fair market value to be adjusted all the time you end up with people making appraisals and stuff that are too high or too low depending on what they're trying to do so we have to use this in concept this idea of fair market value but it's not the easiest thing to come to when you're talking about real estate which is all unique so sale of similar property on or about the same date may be helpful to figuring the fair market value of the property figuring the debt the basis the basis for depreciation is the lesser of the fair market value of the property on the date you changed it to rental use or your adjusted basis on the date of the change that is your original cost or other basis of the property plus the cost of permanent additions or improvements since you acquire it minus deductions for any casualty or theft losses claimed on earlier years income tax returns and other decreases to debt so notice that thinking about the basis of personal property like a home can be a little bit complex because unlike with rental property we don't have to track the basis of the home as closely often times it would be good to do that because when we sell our personal home we might be subject to a gain and we have to deal with that at that point in time but with rental property obviously we depreciate the property so we track it pretty closely with a personal home then you've got to make sure that you get the whole basis in there right so the basis you would think would be once again the cost or basis of the property what you bought the property for plus the cost of permanent additions or improvements big things that you improved a new roof and that kind of stuff minus deductions for any casualty or theft losses claimed on earlier years income tax return so if you had a loss that you claimed because it went down in value or something like that which is less usual to happen and other decreases to the basis so for increase and decreases to basis you could see the basis in chapter 2 example you originally built a house for $140,000 on a lot that cost $14,000 which you used as your home for many years before changing the property to rental use this year you added $28,000 of permanent improvements to the house and claimed a $3,500 casualty loss deduction for the damage to the house so part of the improvements qualifies for a $500 residential energy credit which you claimed on a prior year tax return because land isn't depreciable you can only deduct the cost of the house when figuring the basis for depreciation so the adjusted basis for the house at the time of the change in its use was $164,000 so we're talking about the house here so $140,000 you built a house for $140,000 on a lot that cost $14,000 the lot the land isn't depreciable so we're talking about the building here so we're not adding the $14,000 as a depreciable component before changing the property to rental use you added $28,000 so $28,000 increase because you had permanent improvements to the house and claimed a $3,500 casualty loss so because we got a benefit from the casualty loss we're subtracting a benefit decreasing the basis part of the improvements qualified for a $500 residential energy credit so we're subtracting out the credit okay on the date of the change in use your property had a fair market value of $168,000 of which $21,000 was for land and $147,000 was for the house so the basis for depreciation in the house is the fair market value on the date of the change $167,000 because it is less than your adjusted basis of $164,000 so we have to take the lesser of the two so we had to figure out our adjusted basis and then we're going to figure the fair market value they didn't go into detail on how you figured the fair market value it's basically and you know you could do an assessment an appraisal I mean to try to get the fair market value of related properties and that kind of stuff and then we're taking the basis the property is the fair market value because it is less than the adjusted basis corporates if you change your corporative apartment to rental use figure your allowable depreciation as explained earlier depreciation methods are discussed in chapter 2 of this publication and publication 946 on the basis of all the depreciable real property owned by the corporative housing corporation is the smaller of the following amounts the fair market value of the property on the date you change your apartment to rental use this is considered to be the same as the corporations adjusted basis minus straight line depreciation unless this value is unrealistic the corporations adjusted basis in the property on that date don't subtract depreciation when figuring the corporations adjusted basis stock after its first offering the corporations adjusted basis in the property is the amount figured in one under depreciation earlier the fair market value of the property is considered to be the same as the corporations adjusted basis figured in this way minus straight line depreciation unless the value is unrealistic alright figuring the depreciation deduction to figure the deduction use the depreciation system in effect when you convert your residence to rental use so generally that will be makers for any conversion after 1986 so makers is going to be our general depreciation methods once we put the depreciable property on the books usually treat the property as placed in service on the conversion date example your converted residence see the previous example under figuring the basis earlier was available for rent on August 1st using table 22d see chapter 2 the percent for year one beginning in August is 1.364% and the depreciation deduction for year one is 2005 so in other words once we've determined what the amount is the adjusted basis to put the property on the books at and the date to put the property that was converted from personal use on the books then it's pretty straightforward and that we're doing the same kind of thing we did as though we bought the property right because the difference between purchasing the property and converting the property is the fact that when you purchase the property you know generally pretty well when you bought it and placed it in service and you know generally pretty well what the cost is because you just paid for it when you're converting the property you've got this basis situation that you have to deal with it because you bought it or inherited it or got it in some way in the past and you've got this situation with the partial year you know when you placed it in service or when the conversion happened once you have those two things then you're going to put it on the books and you use the similar method for depreciation for that time frame which is the maker's depreciation usually a straight line type of depreciation with a half month convention