Tax angles when converting your home into a rental You can probably shelter most of the rental income with tax deductions

Tax angles when converting your home into a rental

You can probably shelter most of the rental income with tax deductions

By Bill Bischoff

If your local real estate market is on the upswing, you might be thinking about becoming a landlord. You might even consider doubling down by renting out your current residence and buying another place to live in. If you convert your residence into a rental, you can probably shelter most or all of the rental income with tax deductions, including depreciation write-offs. With any luck, you can eventually sell the property for a good price. Meanwhile, you must navigate confusing tax rules that apply when a personal residence is converted into a rental. Here’s the scoop.

Note: This is the third article in our three-part series on tax issues that current and prospective landlords should understand. See the first two articles here: The tax advantages of being a landlord and More tax advantages of being a landlord

Depreciation Deductions and Loss on Sale May Depend on Special Basis Rule

Depreciation: You can depreciate the tax basis of the building part of a residential rental property (not the land part) over 27.5 years. Depreciation is nice because it allows you to shelter some of your rental income with noncash deductions. However a “special basis rule” applies to a rental property that was formerly your personal residence.

Under the special rule, the initial tax basis of the building portion of the property for purposes of calculating depreciation write-offs equals the lower of: (1) the building’s fair market value (FMV) on the conversion date or (2) the building’s “regular basis” on the conversion date. Regular basis usually equals original cost plus the cost of any improvements (not counting normal repairs and maintenance).

Key Point: If on the conversion date the building’s FMV is lower than the regular basis figure (this is possible if the local market is still in the early recovery phase), you must use the lower FMV number as the basis for calculating depreciation deductions. While this will result in lower depreciation deductions during the rental period, it isn’t a big issue.

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Loss on Sale: The same special basis rule also applies for purposes of determining if you have a deductible loss on sale after converting the property into a rental. So if the property’s FMV is lower than the regular basis amount on the conversion date, you must use the lower FMV figure as the initial basis amount to see if you have a deductible loss when the property is sold. Also, you must reduce the initial basis by depreciation deductions taken during the rental period. The special basis rule and the depreciation deductions greatly reduce the odds of having a deductible loss. Just a year or so ago, being able to claim a deductible loss on sale was a big issue because property values were still bumping along the bottom in many places. Now, with many markets improving dramatically, you’re probably more likely to have a taxable gain when you sell than a deductible loss.

Gain on Sale Depends on Regular Basis Rule

When you eventually sell the converted property, the basis for purposes of calculating whether you have a taxable gain on sale is the property’s regular basis on the sale date. Regular basis generally equals the original cost of the land and building plus the cost of any improvements minus depreciation deductions claimed during the rental period.

Different Basis Rules Can Produce Weird Tax Results When Property Is Sold

When you sell the converted property, the tax results might be surprising. That is because you must use the special basis rule to determine if you have a deductible loss on sale, but you must use the regular basis rule to determine if you have a taxable gain. Following two different basis rules can sometimes put you in no man’s land where you have neither a taxable gain nor a deductible loss. In fact, that is exactly what will happen whenever the sale price falls between the two basis numbers. I know this is confusing, so here are some examples.

Example 1: No Tax Gain and No Tax Loss on Sale

Your converted property is in a market that has bounced off the bottom but not all the way back to its earlier peak by the time you sell. Assume the following numbers for the property.

1. 1. Regular basis on conversion date: $300,000
2. 2. FMV on conversion date: 235,000
3. 3. Post-conversion depreciation deductions: 13,000
4. 4. Special basis for tax loss (line 2 – line 3): 222,000
5. 5. Regular basis for tax gain (line 1 – line 3): 287,000
6. 6. Net sale price: 275,000
7. 7. Tax loss (excess of line 4 over line 6): none
8. 8. Tax gain (excess of line 6 over line 5): none

Explanation: Because the sale price falls between the two basis numbers, you have no tax gain and no tax loss. Strange but true!

Example 2: Decent Gain on Sale

Your converted property is in a recovering market, and you intend to hang on for a while before selling. Assume the following numbers apply to the property when you sell.

1. 1. Regular basis on conversion date: $300,000
2. 2. FMV on conversion date: 285,000
3. 3. Post-conversion depreciation deductions: 32,000
4. 4. Special basis for tax loss (line 2 – line 3): 253,000
5. 5. Regular basis for tax gain (line 1 – line 3): 268,000
6. 6. Net sale price: 345,000
7. 7. Tax loss (excess of line 4 over line 6): none
8. 8. Tax gain (excess of line 6 over line 5): 77,000

Explanation: The post-conversion depreciation deductions reduced the regular basis and the value of the property jumped. As a result, the sale price exceeds the regular basis, which produces a medium-size taxable gain.

Example 3: Bigger Gain on Sale

Your converted property is in a strong market. You’ve owned the property for quite a while and its value never came close to falling below what you paid for it. In this case, the special basis rule for determining if you have a tax loss doesn’t apply. Assume the following numbers when you sell.

1. 1. Basis on conversion date: $235,000
2. 2. FMV on conversion date: 285,000
3. 3. Post-conversion depreciation deductions: 26,000
4. 4. Basis for calculating tax gain or loss (line 1 – line 3): 209,000
5. 5. Net sale price: 360,000
6. 6. Tax loss (excess of line 4 over line 5): none
7. 7. Tax gain (excess of line 5 over line 4): 151,000

Explanation: The post-conversion depreciation deductions reduced the property’s basis and the value jumped after the conversion. So the sale price substantially exceeds the basis, which produces a significant taxable gain.

Can You Shelter Taxable Gain on Sale with Principal Residence Gain Exclusion Break?

It depends. The principal residence gain exclusion break is only allowed if you’ve rented the property for no more than three years after the conversion date by the time you sell. That is because you must have used the property as your principal residence for at least two years during the five-year period ending on the sale date to qualify. Once you’ve rented the property for more than three years during that five-year period, you can’t meet the two-year requirement and the gain exclusion becomes unavailable.

When allowed, the gain exclusion really helps. Unmarried property owners can potentially exclude gains of up to $250,000, and married joint-filing couples can potentially exclude up to $500,000. One more detail: even if you qualify, you can’t use the exclusion to shelter the part of a gain that is attributable to depreciation deductions.