Sale of personal residence with converted "assessory building" on property

[origun]

Taxpayer bought a home for a personal residence about 10 years ago which had a small “accessory building”. About 5 years ago he converted the accessory building to a rental, sort of like a mother-in-law’s cottage, and has been renting it since then, depreciating conversion expenses and a new roof installed later (about $10,000 total).

He is planning on selling the property in 2019 and wants to know tax consequences. The Assessor’s record doesn’t separate the value of the 2 residential units and combines the square footages as if one building and there have been no appraisals separating the 2 buildings. I’m not sure how to break down the basis and the selling price between the residence and the rental. Then I’ll have depreciation recapture to deal with and I have that information.

To simplify, if the residence has 1500 sq. ft and the rental 500, after taking out the value of the land, would it be appropriate to prorate the “Improvement” part of sale based on square footage (25% to rental, 75% to personal residence)? Possibly an irrelevant bit of information but when sold, the buildings will be torn down and multi-family housing built on the property so the current value of the property is the land, not buildings...so the value of the buildings will be irrelevant to any prospective buyer.

I’d appreciate any suggestions so I can advise client of upcoming tax consequences.

[Burke]

He could pro-rate the original cost 75/25 using that to apportion to rental. But he should know what capital improvements (i.e, roof, etc) were done to each individual structure. Its only been 5 yrs. What has he been depreciating besides the building itself?

[origun]

He has been depreciating initial conversion costs (probably including paint, flooring, appliances, countertops, plumbing fixtures--all I have is the date and total am't.) and a new roof 2 years ago. Perhaps that was not done correctly at time of conversion...but that is what happened and what I have to deal with.

[ATSMAN]

I have 2 such clients who at one time had a mother-in-law apartment joined to the main house but also had separate entrance. In our town the property records show the combined valuation and taxes. So I have treated these type of rental situations like Duplex rental. Take the property tax, mortgage interest, repairs etc and go 50% on Sch E.

[origun]

Atsman, Thanks for your reply; it agrees with what I have been doing and will continue to do until sold and owner has paid taxes on a net profit every year. My concern is what to do when it sells. I don't want to have to split the basis and selling price as the accessory building is worth way less than the personal residence and it is going to be torn down! The gain will be on the land, not the personal residence or the accessory building. I guess I am looking for a legitimate way out of a big gain on a small investment!

[Burke]

He could have an appraisal done on the buildings themselves and then use that ratio. Treated as income-producing property, the accessory building may be worth more than he thinks. Unfortunately, unless he dies before it is sold, he is stuck with the gain as is on the entire property. Future use does not factor into it, nor the fact that the buildings will be demolished.