Forms Needed For Sale of Investment Rental Property

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  • #4680
    fairira
    Participant

    Your help on either of 2 questions will be greatly appreciated.

    A 55 year-old health services worker has owned a California rental property (a house and lot) for many years so it is almost fully depreciated. He now expects to sell it next year and will not claim any of the capital gain exclusion available to a person who lives in their property for 2 of the last 5 years.

    He knows that he will need to file Forms 8949 and Schedule D where he will include his unrecaptured depreciation on line 19. He also intends to file Form 4952 (Investment Interest Expense Deduction). Because his total accrued investment interest expense is more than his expected capital gain and unrecaptured depreciation which he will elect to take as ordinary income, he will not have to pay any income tax on the sale of his rental property.

    Q. 1: Does he also need to file Form 4797 even though this is just an investment and he is not in the trade or business of renting real property? The form seems unnecessary to me and complicated by instructions that the sale of the house goes in Part III of the 4797 as a Sec. 1250 Property but the sale of the land goes on Part I of the 4797. This seems to count as two sales on Form 4797 but one as a Schedule D capital asset.

    Furthermore, Publ. 544 includes: “Generally, gain from the sale or exchange of depreciable property not used in a trade or business but held for investment or for use in a not-for-profit activity is capital gain. Generally, the gain is reported on Form 8949 and Schedule D.”

    Q. 2: If he wants to attach an Explanation Statement to clarify his filing and why no income tax is due, can he e-file or must he file a paper return for the IRS to receive his explanation (regardless of whether they read it)?

    Thank you very much for any helpful information.

    #4684
    ruth
    Participant

    Q1: Publication 544 also states (see item 3 on p. 20 under Noncapital Assets) that sales of rental property (even if fully depreciated) are reported using the rules discussed in Chapter 3. The middle column of page 26 under “Section 1231 Transactions”) states “Generally, property held for the production of rents or royalties is considered to be used in a trade or business.” The sale must be reported on Form 4797, which is needed to figure the amount of unrecaptured 1250 gain (see the worksheet on page D-14 of the Schedule D instructions).

    The reason the land is reported in Part I and the building is reported in Part III is to properly figure the amount of unrecaptured 1250 gain. Allocate the basis and sales price between the land and building.

    Q2. Because renting real estate is considered a trade or business for many purposes (including, for example net operating losses), I don’t believe the gain from the sale of the property is treated as gain from investment property for purposes of Form 4952, but I can’t find anything that specifically addresses this issue. But if you want to take this position and properly complete Forms 4797 and 4952, no statement should be required. I don’t know whether e-filing allows the option to attach a statement of explanation.

    #4686
    fairira
    Participant

    Thank you very much, Ruth, for your informative comments.

    Perhaps common sense does not apply but to me there seems a clear difference between a rental property held as an investment and one used in a trade or business. Schedule E’s Part I heading is “Income or Loss From Rental Real Estate and Royalties Note: If you are in the business of renting personal property, use Schedule C (see instructions).” This owner has not filed Schedule C and I assume he should not have since this is a passive activity investment that takes him less than 10 hours a year.

    While Publ. 544 does state “Generally, property held for the production of rents or royalties is considered to be used in a trade or business,” its owner originally purchased it to live in. When he moved out of California over 10 years ago, he decided to keep it as an investment property since he anticipated an increase in its future market value. He converted it to a rental property rather than leave it unoccupied but did not hold it for the production of rental income which has been small and less than 1% of his income.

    These facts may or may not change whether Form 4797 is required but his retention of the property was always intended as an investment. He wants to use Form 4952 since his accrued investment interest expense is more than his expected capital gain and unrecaptured depreciation, both of which he will elect to take as ordinary income. Form 4952’s line 4d is for the “Net gain from the disposition of property held for investment” and so he wants to be consistent that his rental property is an investment and not property used in a business or trade when Form 4797 would presumably be needed.

    I would appreciate if you would be kind enough to comment further.

    Thank you.

    #4689
    snargle
    Participant

    Have you looked at Tax Code Section 163(d)(4)(D) as it might apply to this rental activity? A rental activity is a passive activity under Section 469 and not an investment. I wish I didn’t have to point this out.

    • This reply was modified 1 month ago by  snargle.
    #4692
    fairira
    Participant

    snargle,

    Thank you for pointing out that a rental activity is a passive activity under Section 469. I accept that to be so but I don’t follow why that means it is not also an investment. Please help me understand why if a rental may not be both a passive activity and an investment.

    ruth, in your Oct. 10 post re whether a rental property is a trade or business and not an investment, I saw the following at https://www.irs.gov/faqs/sale-or-trade-of-business-depreciation-rentals

    “Top Frequently Asked Questions for Sale or Trade of Business, Depreciation, Rentals

    “> What forms do we file to report a loss on the sale of a rental property?

    “Answer: Rental property is income-producing property and, if you are in the trade or business of renting real property, report the loss on the sale of rental property on Form 4797, Sales of Business Property. . . . If your rental activity does not rise to the level of a trade or business, but instead is held for investment or for use in a not-for-profit activity, the loss is a capital loss.”

    The point here is that the IRS does recognize that a rental activity may not rise to the level of a business or trade but instead may be held for investment which is the case as outlined in my 2 previous posts. In turn, Form 4797 (Sales of Business Property) should not be necessary.

    snargle, ruth or anyone else, I welcome and appreciate your comments.

    #4694
    snargle
    Participant

    Here’s what I missed on my first try:
    IRC 163(d)(3)(B)(ii) and IRC 469(c)(2), which together seem to take any rental activity out of the “investment” rules, no matter what you would like to call it.

    Sorry for my stumbling around with this.

    • This reply was modified 1 month ago by  snargle.
    #4708
    fairira
    Participant

    snargle,

    Thanks very much for your last post and I see no reason for your polite but apologetic “Sorry for my stumbling around with this.”

    I appreciate your posts citing the pertinent IRC provisions. After reading and pondering them several times, I understand that generally an actual investment in a rental property will be automatically categorized instead as one used in a trade or business, even though no Schedule C would be appropriate.

    It is clearer that this area is over my head and that it would be best to turn the tax return over to a CPA.

    Thanks again.

    #4720
    snargle
    Participant

    fairira,

    I would give you a high five and a fist bump if you had said “an experienced tax professional” instead of “a CPA”.

    snargle

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