Benjamin Franklin once said, “…in this world nothing can be said to be certain, except death and taxes.” Since its tax season, this will the first of a handful of articles that I’ve decided to devote to the long standing relationship between personal income taxes and real estate. Most have a solid understanding of the common benefits, written into the tax code, pertaining to homeownership, but of course there’s much more in terms of rules and regulations for many situations, that are quite important for any homeowner to be aware of.
As mentioned in my last article, regarding the rules pertaining to qualifying for a new mortgage without selling the departure residence, many current homeowners are now making the decision to purchase a new home, and many of those homeowners will either decide, or be forced to (by market conditions) to retain their current home and convert it into a rental property, therefore, I would like to cover the adjustments to your tax return you will experience, should you decide, or be required to convert your principal residence to a rental/investment property, and since you experience many changes with this event, I will be thorough.
What is converting a principal residence to rental property?
If you decide or are required to permanently convert your principal residence to rental/investment property (income-producing property), a number of tax issues will arise. These include computing the tax basis of the property, determining the date when the property was placed in service, knowing which depreciation methods to use, and knowing how to compute the capital gain or loss upon a subsequent sale of the property.
What is a principal residence?
Generally, a dwelling is considered a residence if it has a sleeping space, a toilet, and cooking facilities. Therefore, a residence includes a house, a condominium, mobile home, boat, or house trailer. If you own a residence, it will be treated as your principal residence for federal income tax purposes, if it is your primary place of abode and the number of days that you rent the entire dwelling is limited to less than 15 days during the year. For comparison, a residence other than a principal residence that is used for personal purposes for less than 14 days during the year (or for less than 10 percent of the number of rental days) is referred to as a rental property for federal income tax purposes.
How do you compute the tax basis of a principal residence converted to rental property?
In general, the adjusted tax basis of a principal residence is the cost of the property (i.e., what you paid for the property when you first purchased it), plus amounts paid for capital improvements, less any depreciation and casualty losses claimed for tax purposes. Improvements add value to the home, prolong its life, or adapt it to a new use. Regular repairs and maintenance are not included in the tax basis of the home. When a principal residence is converted to rental property, you need to know its basis for depreciation purposes. Its basis for depreciation purposes is the lesser of:
- The adjusted basis of the residence on the date of conversion, or
- The fair market value of the property at the time of conversion
- What depreciation method is used?
Federal law provides that any real property acquired before 1987 and converted to rental or business use after 1986 is subject to the Modified Accelerated Cost Recovery System (MACRS). Under MACRS, you generally depreciate residential rental property over a 27.5-year period.
How do you calculate the capital gain or loss on the subsequent sale of converted property?
In order to calculate the capital gain or loss when you sell a residence that had been converted to rental property, you need to know three things:
- Your adjusted tax basis in the property (both at the time of the conversion and the time of the sale)
- The sale price
- The fair market value of the property when it was converted to rental property
If the converted property is later sold at a gain, the basis for purposes of determining the capital gain is your adjusted tax basis in the property at the time of the sale. If the sale results in a loss, however, the basis used is the lower of the property’s adjusted tax basis at the time of the conversion or the fair market value when the property was converted from personal use to rental property. This loss rule ensures that any deflation in value occurring while the property was held as a principal residence does not later become deductible upon your sale of the rental property; a loss on the sale of a principal residence is not deductible. As usual, you calculate your capital gain by subtracting your adjusted basis from the sale price of the property.
Example(s): Assume Jack converted his principal residence to income-producing property. The house originally cost him $50,000 and was worth $60,000 when it was converted to rental use. Ten years later, Jack sells the property for $65,000. Over the 10-year rental period, Jack deducted a total of $9,000 in depreciation expenses. His capital gain is computed as follows:
1. Original cost – $50,000
2. FMV at conversion – $60,000
3. Depreciation taken – $9,000
4. Adjusted basis for determining gain (#1 – #3) – $41,000
5. Adjusted basis for determining loss (lesser of #1 – #3 or #2 – #3) – $41,000
6. Sale price – $65,000
7. Capital gain – $24,000
Caution: Unlike the reasonable efforts standard that must be met in order to claim depreciation deductions for rental real estate, you must actually rent out the property in order to claim a deduction for any capital loss on the sale of the property.
Caution: the holding period for converted property (for purposes of capital gain or loss) begins on the date that the property was acquired–not on the conversion date.
What constitutes a conversion of a principal residence to rental property (for purposes of depreciation entitlement)?
In order to be entitled to depreciation deductions, you must move out of the principal residence and make reasonable efforts to rent it. It is satisfactory to list the property for rent or “rent or sale” as long as there is a meaningful expectation of rental income. As long as you make a reasonable effort to obtain rental income, you will not be barred from deducting depreciation expenses if you do not actually receive rental income for a period of time. However, it is not enough for you merely to hold the house for sale without attempting to obtain rental income. You must show that you are seeking a profit as well as seeking deductions for your expenses.
What about passive activity rules and at-risk rules?
Tax rules regarding amounts at-risk and passive activities may pertain to losses generated by rental property. The rental of real estate is generally considered a passive activity (i.e., one in which the owner does not materially participate). Material participation requires you to be involved in the operations of the rental on a regular, continuous, and substantial basis. Typically, deductions for passive activity losses cannot simply be deducted outright on your income tax return; rather, a passive loss can only be used to offset income from other passive activities. Losses not allowed are carried forward to the next tax year. Note, also, that if any amounts invested in a passive activity are not at-risk, the at-risk limits must be applied before the passive loss limitations. Losses are only allowed to the extent of your amount at risk with respect to the activity.
The at-risk rules apply to any activity carried on for the production of income or as a trade or business. Your amount at risk is often identical to your adjusted basis in the property. However, amounts at-risk include amounts borrowed by a taxpayer for use in an activity only if the taxpayer is personally liable.
Of course, everyone’s situation is different, so for specific questions pertaining to yours be sure to contact a tax professional, such as a CPA and/or Enrolled Agent. If you need a recommendation, please contact me, and I will be happy to provide.