Personal residence converted to rental.


C

cmiller

A client is thinking about converting their residence to a rental. It
has declined significantly in value since they purchased it. I know
they will have to use the lower current value for depreciation
purposes. However, what I do not know is what will happen several
years from now when the property is later sold. Is their basis the
value at the time the property was converted to a rental or their
initial basis. While my first reaction was to say the initial value,
I realized this would be converting a non-deductible personal loss
into a deductible loss (or using the personal loss to reduce a taxable
gain), which I know the IRS frowns upon. Is there a regulation or
ruling that addresses this situation? Would the amount of time the
property is held as a rental change the answer? Also, would the
answer be different if the sales price were above the initial purchase
price?
 
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P

Phillip Marti

A client is thinking about converting their residence to a rental. It
has declined significantly in value since they purchased it. I know
they will have to use the lower current value for depreciation
purposes. However, what I do not know is what will happen several
years from now when the property is later sold. Is their basis the
value at the time the property was converted to a rental or their
initial basis.
The lower of the two. I looked this one up not long ago for a friend. I
think it's in Pub 551.
 
J

JoeTaxpayer

Phillip said:
The lower of the two. I looked this one up not long ago for a friend. I
think it's in Pub 551.
Pub 551 - http://tinyurl.com/pub551

I read this differently that either of the OP's choices.

There are two steps - first, one depreciates based on the values when
put into service as a rental. Second, upon sale the basis is the
original (purchase) basis minus the depreciation taken.
This results in neither (of those choices) being the correct basis used
for the final sale.

Joe
www.joetaxpayer.com
 
M

Mark Bole

Phillip said:
The lower of the two. I looked this one up not long ago for a friend. I
think it's in Pub 551.
Yes, it is in Pub 551, the last topic under "Basis Other Than Cost".

It's not necessarily the lower of the two, but rather you use a
different basis for calculating a gain than you do for a loss. An
example of a residence converted to rental is provided in the Pub.

In the same pub, discussing property received as a gift, it is explained
how it is possible to have neither a gain nor a loss upon disposition.
I suppose the same thing could happen with the property converted to
rental use.

Example, assuming a period when real estate values drop and then
partially recover:

Purchase price of residence: $200K
FMV when converted to rental: $120K
Depreciation allowed: $10K
Sale price of rental: $150K

gain = $150K - ($200K - 10K) => loss

loss = $150K - ($120K - 10K) => gain

I would need to do a quick check on whether or how unrecaptured Sec.
1250 gain would be taxed in this example, I don't think it's an issue if
there is in fact no gain (which does not, as show above, necessarily
imply there was a loss).

-Mark Bole
 
L

lotax

Yes, it is in Pub 551, the last topic under "Basis Other Than Cost".

It's not necessarily the lower of the two, but rather you use a
different basis for calculating a gain than you do for a loss. �An
example of a residence converted to rental is provided in the Pub.

In the same pub, discussing property received as a gift, it is explained
how it is possible to have neither a gain nor a loss upon disposition.
I suppose the same thing could happen with the property converted to
rental use.

Example, assuming a period when real estate values drop and then
partially recover:

Purchase price of residence: $200K
FMV when converted to rental: $120K
Depreciation allowed: �$10K
Sale price of rental: $150K

gain = $150K - ($200K - 10K) => loss

loss = $150K - ($120K - 10K) => gain

I would need to do a quick check on whether or how unrecaptured Sec.
1250 gain would be taxed in this example, I don't think it's an issue if
there is in fact no gain (which does not, as show above, necessarily
imply there was a loss).

-Mark Bole
Thank you Mark, and well done. This is a very often overlooked
"subtlety" in the "what's my gain" discussion, which we'll be having
more of nowadays, what with the economy and all.

Using your figures...

Purchase price of residence: $200K
FMV when converted to rental: $120K
Depreciation allowed: $10K
Sale price of rental: $150K

gain = $150K - ($200K - 10K) => loss - none to be taxed
loss = $150K - ($120K - 10K) => gain - none to deduct

There's neither a taxable gain nor a deductible loss when the house
sells for $150K. And with no gain, there's also no unrecaptured
section 1250 gain to deal with, by definition.

Using your figures, still, but changing the sale price to $215K, the
taxable gain would be $25K [selling price less original cost adjusted
for depreciation taken] of which $10K would be potential unrecaptured
section 1250 gain. I say "potential" unrecaptured section 1250 gain
because if there are losses from other things, the section 1250 gain
may be reduced when the gains and losses are netted together.

Is the $25K gain section 1231 gain, because it's rental property being
sold, and/or is that gain excludible from income (except for the $10K
of it that is the gain caused by the depreciation taken) if the
principal residence section 121 rules apply, basically the rental
period was three years or less?
 
D

D. Stussy

Mark Bole said:
Yes, it is in Pub 551, the last topic under "Basis Other Than Cost".

It's not necessarily the lower of the two, but rather you use a
different basis for calculating a gain than you do for a loss. An
example of a residence converted to rental is provided in the Pub.

In the same pub, discussing property received as a gift, it is explained
how it is possible to have neither a gain nor a loss upon disposition.
I suppose the same thing could happen with the property converted to
rental use.

Example, assuming a period when real estate values drop and then
partially recover:

Purchase price of residence: $200K
FMV when converted to rental: $120K
Depreciation allowed: $10K
Sale price of rental: $150K

gain = $150K - ($200K - 10K) => loss

loss = $150K - ($120K - 10K) => gain

I would need to do a quick check on whether or how unrecaptured Sec.
1250 gain would be taxed in this example, I don't think it's an issue if
there is in fact no gain (which does not, as show above, necessarily
imply there was a loss).
That would be be basis for purposes of depreciation. Basis for gain/loss
on sale goes back to the original acquisition.
 
M

Mark Bole

D. Stussy said:
That would be be basis for purposes of depreciation. Basis for gain/loss
on sale goes back to the original acquisition.
But that goes back to the comment in the original post -- are you saying
that the unrealized loss during the period of personal use is now fully
deductible simply because it was converted to a rental?

According to Pub 551, you use a different basis to calculate gain than
to calculate loss, see also § 1.165-9.

-Mark Bole
 
D

D. Stussy

Mark Bole said:
But that goes back to the comment in the original post -- are you saying
that the unrealized loss during the period of personal use is now fully
deductible simply because it was converted to a rental?
No. However, it's still the starting point. There's still some implied
consumption (which would be [non-accelerated] depreciation had the asset
been placed in service from day one) that adjusts the basis, but blindly
using the [lower] FMV at the time of conversion also isn't correct.
According to Pub 551, you use a different basis to calculate gain than
to calculate loss, see also § 1.165-9.
Without reviewing the TR, my instinct says that is wrong. However, I agree
that not all of the loss would be deductible due to the personal use
period. However, as I practice in California, where except for the past 2
years assets always appreciated in value, this generally isn't seen.
 
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M

Mark Bole

D. Stussy said:
but blindly
using the [lower] FMV at the time of conversion also isn't correct.
Without reviewing the TR, my instinct says that is wrong.
Instead of the admittedly blind trying to lead the allegedly blind,
let's view the exact quote from Pub 551, which is echoed in the TR:

"Sale of property. If you later sell or dispose of property changed to
business or rental use, the basis of the property you use will depend on
whether you are figuring gain or loss.

"Gain. The basis for figuring a gain is your adjusted basis when you
sell the property. [example omitted]

"Loss. Figure the basis for a loss starting with the smaller of your
adjusted basis or the FMV of the property at the time of the change to
business or rental use. Then adjust this amount for the period after the
change in the property's use, as discussed earlier under Adjusted Basis,
to arrive at a basis for loss. "

-Mark Bole
 

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