Q: My question revolves around how to calculate the cost basis of a rental property. The property was originally a personal residence but has now been transferred into a sole-member limited liability company (LLC) and is being rented.
My son acquired his personal residence in 2014. While living in it, he made a number of improvements to it. He did almost all of the improvements by himself, though I also provided some free labor. In early 2017, he undertook two large remodeling projects to his home, remodeling a full guest bath and the entire kitchen/laundry areas. While we can probably pull together a significant portion of the material costs involved in those two projects, we did not keep track of the hours spent working on the renovations.
In mid-2017 he accepted a new job, which required him to relocate out of the U.S. Since he really liked the house, he decided he would rent it out during the years he was overseas. He formed a sole-member LLC in mid-2017 and transferred the house into the new LLC (via quitclaim deed). He then started renting the house under a multi-year lease.
When he transferred the house into the LLC he didn't get an appraisal or market survey/study done. While he does have the original cost of the home, and maybe a good portion of the improvements made to the house in 2015, 2016 and 2017, we have no idea how to come up with the cost basis for the asset. He will need to have a basis for the rental property so he can begin to depreciate it for tax purposes in 2017, and beyond.
I realize that we should have thought about these questions last year as he was improving the property, and before he transferred it into the LLC. Can you suggest our next step to determine the basis of his rental property? Does the IRS publish some guidelines somewhere?
A: In hindsight, we probably would not have recommended that your son transfer title of the home to the limited liability company (LLC). His personal ownership interest, and now his investment ownership of the home, are, and have made, his taxes quite complicated. In fact, we're pretty sure you don't know how complicated they have been made by his transferring title to the property to the LLC.
In general, if you own a personal residence and convert that to home into a rental property, there are several issues that pop up. The first is that you may lose real estate tax benefits (including a "homeowners exemption") that your local real estate taxing body gives to homeowners that live in their homes as their primary residence. The second is that the residential lender that gave your son his loan may, but is not required to, call the loan. In other words, the lender can require repayment of the loan due to the sale of the property.
Now that the home is in the name of the LLC, the property insurance should be in the name of the LLC as well. The lender will get notified of the change of ownership and the lender can decide whether to continue to receive payment on the loan or call it due. Another federal income tax issue that will come up is that your son may lose the benefits of the tax exclusion when he goes to sell the home.
Your son is entitled to exclude up to $250,000 in profit ($500,000 if he is married) from the sale of his primary residence if he lived in the home for two out of the last five years. Of course, if he sells in the next year or two, he'll get the benefit; but if he ends up leasing the home for the next three years, he won't get the tax exclusion unless he moves back into the home. If there is little or no profit, this may not matter. But if the property is in a fast-appreciating neighborhood, your son may wind up paying capital gains tax when he sells, plus recapturing any depreciation he takes over time (which might be worth it, if he intends to keep the property as a rental for a longer period).
Let's shift and talk about the basis of the home. Basis is a word used by the IRS that refers to the total amount the property costs you. In the most simplistic form, your basis is the purchase price on the home, the cost to purchase the home that the IRS allows to be included in the basis, major improvements you make to the home that the IRS classifies as allowable to be included in basis, and any allowable costs of sale (including a broker's commission).
You can review some of these on the non-investment side by looking over Publication 523 on the IRS website. For rental properties you can read Publication 527 on the IRS site.
Your son would be wise to find the receipts for the materials he put into the house; if he ever gets audited, the IRS might require some proof of what was put in for him to justify his basis.
On the question of your labor and his labor that was put into the home, we're sorry to tell you that you can't include it in the basis. You can only include in basis the cost of labor you paid for. While this might seem unfair, if the IRS allowed anyone to claim they put any number of hours into renovating a bathroom themselves, it would be very difficult to justify and apply fairly. So, your own labor cannot be claimed.
Finally, by putting the home into an LLC, your son will have to determine whether that transfer constitutes a sale of the home to the LLC. If it is a sale, then the basis to the LLC is the price the LLC paid for the home and your son's selling price would be what he received for the home. We're going assume that no money passed between your son and the LLC and that he's thinking that the LLC and his ownership are one and the same.
In this case, he should have a conversation with a tax professional, such as an Enrolled Agent or accountant, who can help him understand where he stands. Once a determination is made about the basis of the property from the personal side and LLC's business side, he and the tax professional can then determine how the amortization will be structured and how it might (or might not) benefit him on his income tax return.
(Ilyce Glink is the author of “100 Questions Every First-Time Home Buyer Should Ask” (4th Edition). She is also the CEO of Best Money Moves, an app that employers provide to employees to measure and dial down financial stress. Samuel J. Tamkin is a Chicago-based real estate attorney. Contact Ilyce and Sam through her website, ThinkGlink.com.)