Ask a CPA: Selling a House and Tax Deductions

by A CPA

My wife and I lived in a home for more than 10 years. In August of 2014, we moved out and put it into service as a rental. We intend to sell the house when our current tenants move out (their lease is up at the end of August of 2015, but we’ve told them they can move out earlier if they want and they’ve indicated that they may).

We should (knock wood) be able to sell the house before the end of 2015. However, we’re probably going to do some work on the house to get it into better shape to sell, and I anticipate the house may be unoccupied for 1–3 months before we sell it. My understanding is that, because we will have lived in the house for four of the last five years, we won’t have to pay any capital gains on the sale. I’m wondering, though, how much (if any) of the following expenses we can use as expenses to offset rental income:

• Money spent on repairs/improvements on the house after the tenants move out but before the house is sold
• Mortgage interest, property taxes, and utilities paid after the tenants move out but before the house is sold
• Depreciation for the period after the tenants move out but before the house is sold
• Expenses related to the home sale, such as paying to have the house staged
• The realtor’s fee once we actually sell the house

Thanks in advance for any advice you can offer!

— Anonymous

Dear Anonymous,

Congrats on owning two homes concurrently! It’s quite rare as people who “upgrade” from one house to another usually do so on a contingency basis and requires two house closings on the same day. Super stressful!

According to IRS Publication Pub 523, you need only to use the house as your personal residence two out of the prior five years to qualify for the exclusion. So you have until August 2016 to sell your house to qualify (assuming all of the other conditions in the IRS publication are still met).

Residential rentals are a GREAT way obtain first page deductions on your tax return; in fact, maybe 1 in 4 returns that have rentals that I work on are profitable, and generally all of those are multi-units. Even if you earn too much on your day job and can’t take the yearly losses, you get to take ALL OF THEM the year you sell it. Sweet, sweet, ordinary loss.

Note: I’m glossing over some stressful things about being a landlord like destructive or deadbeat tenants and surprise capital repairs. There’s more! But let’s not dirty our minds here.

Any modest profit from a residential rental is doomed because:

• Inexperienced landlords reduce rent to market to keep the place occupied
• Depreciation on the entire house
• Other “management” deductions the landlord can take, like a portion of their cell phone and mileage

Generally as long as your house is “available for rent,” you may take any deductions associated with the rental on the rental (Schedule E) and not lost to the ages when you sell your house. So, keep a postage-sized ad next to the smut section of the dirtiest rag (newspaper) in your city, use an exorbitant rent number, and take those sweet repair/mortgage interest/real estate taxes/utilities on your tax return.

You know how I said depreciation is awesome and creates losses in the current year? Well, it is, but you have to pay up one day. If it is a long-term rental property and you sell the rental for anywhere near you purchased it at, you’ll have a long-term capital gain roughly equal to the amount you depreciated. It’s not the worst kind of gain, but it is a gain.

In your situation, I don’t recommend taking depreciation because it may raise a red flag with the IRS: you’d be claiming depreciation and generating ordinary losses one year, then taking a capital gain the next, all the while taking the home ownership exclusion.

Example: Your house is worth $100,000, you assign 20% to land, so your depreciable basis is $80,000. Year 1 you take $2,909 in depreciation ($80,000/27.5), and you sell it January 1st of year 2: you will have to pay a gain on $2,909.

Lastly, I’d keep home selling expenses and definitely your realtor’s fees out of the rental entity. Those are selling expenses and should only be reported on the disposal of the property.

Sincerely,

A CPA

This story is part of our Tax Month series, which we’ve just wrapped up.

A CPA works at a Midwest public accounting firm completing individual taxes among other accounting engagements. Previously, he worked in radio promotions and routinely judged pudding wrestling matches at suburban bars. Any tax advice contained in this communication is not intended as a thorough, in depth analysis of specific issues, nor a substitute for a formal opinion. Consult your own tax adviser for more info. Or else.

Photo: Ben Ledbetter

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