USA 4797 conundrum - sale of residence converted to rental property

[developer]

I purchased my previous residence in 2006, which I later converted to rental property in 2014. I sold the house last year, so I'm reporting the sale on Form 4797. The instructions don't explain how to handle my specific situation.

According to Pub 551 (page 11), the basis when reporting the sale of rental property depends on whether there's a gain or loss. If there's a gain, the basis for calculating the gain is the original cost plus improvements (adjusted basis). On the other hand, if there's a loss, the basis is the lesser of the adjusted basis or the fair market value at the time of conversion. In this case, because our local market had yet to recover from 2008-2009 crash, the FMV in 2014 was significantly lower than the adjusted basis. The leads to a conundrum.

Using the original price plus improvements less depreciation, there's a small loss. According to Pub 551, I must use FMV at conversion when reporting a loss (in my case, FMV is lower than adjusted basis). However, if I use FMV less depreciation, there's a gain! So in this situation, there's no reportable gain or loss. Given the intent of the rules, this makes perfect sense. The question is how to report that on 4797, if at all?

 

[developer]

In case anyone doubts my assertion that there may be situations where there's no reportable gain or loss, here's the relevant excerpt from Pub 551:

Property Changed to Business or Rental Use (page 11)
Sale of property. If you later sell or dispose of property changed to business or rental use, the basis of the property you use will depend on whether you're figuring gain or loss.
Gain. The basis for figuring a gain is your adjusted basis when you sell the property
Loss. Figure the basis for a loss starting with the smaller of your adjusted basis or the FMV of the property at the time of the change to
business or rental use. Then adjust this amount for the period after the change in the property's use, as discussed earlier under Adjusted Basis, to arrive at a basis for loss.

Pub 551 explains how this can happen under the "Property Received as a Gift" section (page 9), which is subject to the same basis rules:

If you use the donor's adjusted basis for figuring a gain and get a loss, and then use the FMV for figuring a loss and have a gain, you have neither gain nor loss on the sale or disposition of the property.

My question is how (or whether) to report a sale when this situation occurs. Having given this more thought, I think filing a 4797 would cause confusion since either basis method I use would be wrong. I could submit an explanation in lieu of Sch D/4797 showing the calculation both ways. Or I could simply not report the sale. What do you think?

 

[BIG E]

Since you have determined the FMV on date of conversion for basis purposes, have you factored out the ratio of the land vs building for calculating the depreciation? The land isn't depreciable but the building is?
When you prepare Form 4797 - you also allocate land vs building on the selling price and closing costs.
The land gets reported on P. 1, the building on P. 2

 

[developer]

The same issue exists for the land... FMV of the land at date of conversion was low, so it shows a gain. However, when reporting a gain, I must use the original cost basis. The original cost basis shows a loss. In that case, as I cited previously from 551, there's neither a gain or a loss.

 

[BIG E]

Once you convert - you use lower of cost or FMV - you don't get to choose which value for which asset - must use lower conversion value for both.

 

[developer]

I didn't say I get to chose.. the rules say which I must use. In this case, the land and building both show a loss when using original basis (adjusted basis for the building), so I must use FMV, in which both land and building show a gain. However, FMV is only applicable in this situation when reporting a loss. The rules say I must start from original basis when reporting a gain. Therefore, there's no gain or loss. This situation is anticipated in the 551 text, as I cited above. It just doesn't say what to do in that case.

That still leaves my question: do I attach an explanation in lieu of a 4797, or simply not report the sale?

 

[BIG E]

Do as you wish. I won't respond any more -

 

[TaxCrunch]

You should not omit the sale from the return, that will only cause you problems (especially if you have a 1099-S issued). File the Form 4797 as usual - with the correct reported amount of proceeds. Simply make the cost basis equal the proceeds, netting out to a zero transaction. You could attach an electronic note to the return as well, but it's unlikely it would be needed. As long as the proceeds match the 1099-S, the IRS has no reason to look further.

 

[developer]

Thanks TC, I hadn't considered entering an incorrect cost basis to force a 0 gain. Even though the IRS is unlikely to question this, I should attach an explanation as I'm not in the habit of knowingly entering false data on my tax returns!

For those who doubt the no-reportable-loss, no-reportable-gain scenario, I'm attaching an example from a respected continuing ed program that describes this exact scenario, but without explanation as to how to report.

 

[TaxCrunch]

I'd have to disagree with you on contending that you're reporting "false data on the return". If the IRS doesn't give any simple explanations, or limited instruction on how to actually report it, sometimes you have to just use common sense to get to the proper result. One of the problems I encounter is that 98% of tax discussions center around the topic itself, and then very focus is left for how to actually report the tax topic on a tax return. It gets very frustrating when the IRS issues limited guidance for preparers. So, if the IRS doesn't leave specific instructions or special dedicated forms, it leaves us to improvise with whatever tools we have via our tax software. After 25 years of preparing returns, I have confidence that if I do what I think is the best and fairest maneuver to stay compliant - I'm not really worried about any IRS static. And the truth is, they're just looking to get to the proper result, following the spirit of each tax law.

 

[developer]

Thanks TC. What you say makes perfect sense... Entering an incorrect basis in itself obviously isn't going to trigger an audit, and if I were audited, my 4797 entries would be simple enough to explain and document.

Since I'm not a professional, I don't have years of experience to inform this sort of ambiguity. My tax returns are normally way too simple to require professional help. I think this may be the first time I've ever filed a Sch D!

 

[TaxCrunch]

With the rising and misleading hidden costs of the do-it-yourself tax software, having professional help is a much better idea - even for relatively simple returns. The reality is that a tax professional has a much better chance of filing an accurate return, and avoiding the red flags that occur frequently with self-prepared returns. On the other hand, your return can be selected for an audit simply by being associated with an overly-aggressive or bad tax preparer. Once the preparer gets flagged, all the returns they've signed off on are susceptible for review (since the preparer has a history of aggressive reporting). So, tax preparers are good - but stay away from the sketchy ones!

 

[developer]

I would be a tax pro's worst nightmare. (I have some experience with that in years past!)

I purposely avoid DIY tax software. Having an accounting and software development background, I tend to obsess over inconsistencies and bugs in the software, and would undoubtedly end up spending far more time posting in support forums and/or dealing with software providers than I will ever spend filling out paper returns .

This year I'm likely to get a 'bonus' for filing a paper return. I had large 401k withdrawal with mandatory 20% withholding, most of which will be refunded. Since the IRS is so far behind on processing paper returns, they'll likely have to pay me interest, and their statutory rate is 10 times what I currently get on my cash.

 

[TaxCrunch]

Yes, I will concur - you would be a preparer's worst nightmare! Take advantage of the paper returns while you can. They have a "soft" e*filing requirement now - which you can obviously still avoid. In the future, it's possible they stop paper processing altogether. With them, who knows?

 

[developer]

Yes, I fear that day will come. At that point I'll probably let someone handle it for me. Hopefully as long as my returns stay simple, there won't be much opportunity for me to question their work

BTW, my father was a CPA. He retired in 1976. His first was among the first in the region to purchase a mini computer. His firm still exists with his name. I think they have about a dozen partners.

Thanks again for your help!

 

[bulltrader1964]

Thanks TC, I hadn't considered entering an incorrect cost basis to force a 0 gain. Even though the IRS is unlikely to question this, I should attach an explanation as I'm not in the habit of knowingly entering false data on my tax returns!

For those who doubt the no-reportable-loss, no-reportable-gain scenario, I'm attaching an example from a respected continuing ed program that describes this exact scenario, but without explanation as to how to report.

Thanks TC. What you say makes perfect sense... Entering an incorrect basis in itself obviously isn't going to trigger an audit, and if I were audited, my 4797 entries would be simple enough to explain and document.

Since I'm not a professional, I don't have years of experience to inform this sort of ambiguity. My tax returns are normally way too simple to require professional help. I think this may be the first time I've ever filed a Sch D!
[/QU

Thanks TC, I hadn't considered entering an incorrect cost basis to force a 0 gain. Even though the IRS is unlikely to question this, I should attach an explanation as I'm not in the habit of knowingly entering false data on my tax returns!

For those who doubt the no-reportable-loss, no-reportable-gain scenario, I'm attaching an example from a respected continuing ed program that describes this exact scenario, but without explanation as to how to report.

I was just wondering, what did you end up doing. I am in a similar situation, zero gain zero loss, and not sure what to do.

 

[developer]

I was just wondering, what did you end up doing. I am in a similar situation, zero gain zero loss, and not sure what to do.

I did what I said in the post you quoted (changed cost basis so as to force 0 gain and attached explanatory note). One complicating factor that Big E mentioned: the land is typically listed separately on 4797. In my case, the situation was the same for both land and building. If the land had showed a loss using FMV at conversion (and a gain using original basis), it could offset part or all of the gain on the house using FMV at conversion (and offset part or all of the loss using original basis), which means the basis to force a 0 overall gain/loss would have been different.

 

[bulltrader1964]

I did what I said in the post you quoted (changed cost basis so as to force 0 gain and attached explanatory note). One complicating factor that Big E mentioned: the land is typically listed separately on 4797. In my case, the situation was the same for both land and building. If the land had showed a loss using FMV at conversion (and a gain using original basis), it could offset part or all of the gain on the house using FMV at conversion (and offset part or all of the loss using original basis), which means the basis to force a 0 overall gain/loss would have been different.

Soooo grey. No clear instructions. Anyways, I am using the HR block software. Put the numbers in under the gain Part III and it ended being zero not a negative number. I'm wondering if I should just leave it. Still nervous about changing the adjusted cost basis to make it zero. I'll tell you what, I felt better after finding this forum that I am not the only crazy person out there.

 

[developer]

Part III only applies when there's a gain, in this case, gains subject to Section 1245 recapture rules. I made my entries in Part I.

 

[bulltrader1964]

Part III only applies when there's a gain, in this case, gains subject to Section 1245 recapture rules. I made my entries in Part I.

Ok Thanks Developer. If you don’t mind, I’d like to share with you my numbers. I purchased the property in 2006, converted to rental in 2013 and sold in 2020. Original purchase $357k. FMV in 2013 was 209k. Sold in 2020 for $325k. Depreciation $56k. Improvements $20k I’m no professional, my taxes have been simple, until now, my understanding is if it is a loss you use the FMV (starting basis + improvements etc) and for a gain you use the original price (starting basis + improvements etc)? Sale price is between FMV and original price. No loss no gain. Part 1? Or Part 3? I do thank you for any input. So funny that these people who make the software have no clue. I am trying to get an appointment with a local CPA but is challenging.