As we have seen the real estate market fluctuate over the past decade, there have been times when a taxpayer has been unable to sale their personal residence at a price satisfactory to them. A taxpayer may sell their property at a gain and exclude some or all of the gain form their income. Internal Revenue Code Section 121 allows an exclusion of $250,000 ($500,000 on a joint tax return) of any gain on the sale of a personal residence. Therefore, a taxpayer may not be required to include any potential gain on the sale of their personal residence in their income but still not want to sale their personal residence due to a low selling price.
A taxpayer may also be in a situation that they are selling their personal residence at a loss as the fair market value (or potential selling price) is now less than the original cost of the property. For these reasons, a taxpayer may consider converting their personal residence to rental property. They may assume that they can convert a nondeductible personal loss on the sale of the personal residence to a deductible loss simply by converting the personal residence into rental property. However, there are special basis rules that apply to a conversion that many taxpayers are unaware of.
When a personal residence is converted to business use (or for use in the production of income), its starting point as basis for depreciation is the lower of
- the adjusted basis on the date of conversion, or
- the property’s fair market value (FMV) at the time of conversion 1
J purchased a home in Boston in 2004 for $250,000, of which $50,000 represented the cost of the land. J lived in the home until 2008, when he moved to New York. Rather than sell the house, he converted it to a rental property. The property’s FMV, excluding the land, on its conversion to rental property was $185,000. J’s basis for depreciation is $185,000, the FMV at the time of conversion, since it was less than the adjusted basis.
Taxpayers must depreciate the converted property based on the depreciation methods and lives in effect in the year of conversion. The depreciation methods and lives in effect in the year of original purchase are irrelevant. Currently, a personal residence converted to rental property would be depreciated over a 27.5 year life if the property is residential. Nonresidential property would be depreciated over a 39.0 year life. 2
Another tax nuance related to a conversion of your personal residence to rental property centers around the eventual sale of the property and the potential gain or loss calculation. The basis of the property is calculated differently depending on whether the sale results in a gain or a loss. When the property is sold at a gain the basis is the original cost plus amounts paid for capital improvements, less any depreciation taken. When the property is sold at a loss the starting point for the basis is the lower of the property original cost or the fair market value at the time it was converted from a personal residence to rental property. Keep in mind that you may still be eligible for the $250,000 (or $500,000) gain exclusion if the converted personal residence is rented for three years or less prior to being sold. The exclusion will not however apply to any depreciation previously taken on the converted personal residence.
Mary converts her personal residence to rental property five years ago. The residence originally cost $ 300,000. Its fair market value was $235,000, when it was converted to a rental property. Over the 5 years $25,000 in depreciation was taken. Mary sold her property for $205,000. This results in a tax loss because the selling price is significantly lower than the fair market value on the conversion date.
- Original Cost: $300,000
- Fair Market Value on Conversion Date: $235,000
- Depreciation Taken: $25,000
- Basis for Tax Loss (Line 2 – Line 3): $210,000
- Basis for Tax Gain (Line 1 – Line 3): $275,000
- Net Sales Price: $205,000
- Tax Loss (Excess of Line 4 over Line 6): $5,000
- Tax Gain (Excess of Line 6 over Line 5): $0
A tax loss of $5,000 results in the above example. The tax loss would only be available to the taxpayer if they can establish that the converted personal residence was permanently converted into income-producing property and was not merely being rented on a temporary basis until being sold.
Taxpayers need to be aware of the special tax consequences that can apply to the conversion of a personal residence to a rental property. The special basis rules may eliminate what many taxpayers perceive as a potential deductible loss on sale through conversion by creating a basis in the property at the lesser fair market value (or potential selling price) amount. A taxpayer may also lose any potential gain exclusion if the time period of rental exceeds three years or more. It is always imperative that you discuss any potential conversion of a personal residence to a rental property with your tax advisor. As you can see there is far more to consider prior to converting your personal residence to rental property than appears at first glance.
- Internal Revenue Code Regulations. Sec. 1.168(i)-4(b)
- Internal Revenue Code Section 168(c)