If you are unable to sell your home for a reasonable price you may be thinking about renting it until the market improves. However, when converting your principle home into a rental property there are some tax issues to consider. The major issue is whether any gain from the eventual sale of the residence will continue to qualify for the exclusion from income. The property’s basis, when the property is placed in service, which depreciation method is used and how to determine the gain or loss when the property is sold requires careful thought and planning.
The first year your property is rented you need to determine whether it is a vacation home or a rental property with personal use. If the personal use exceeds the greater of 14 days or 10% of the number of days during the year the unit is rented, then the property will be classified as a vacation home. If the property is classified as a vacation home the amount of expenses deducted cannot exceed the rental income.
You can escape taxation on up to $250,000 ($500,000 for certain married couples filing joint returns) of gain on the sale of your home. However, this tax-free treatment is conditioned on you having used the residence as your principal residence for at least two of the five years preceding the sale. The tax break will not apply to the extent of any depreciation allowable with respect to the rental or business used of the home for the periods after May 6, 1997. A maximum tax rate of 25% applies to this gain.
When the property is converted the basis for depreciation is the lower of the adjusted basis on the date of conversion or the Fair Market Value (FMV) of the property at the time of conversion. Generally the basis is the cost of the property plus the amounts paid for capital improvements, less any depreciation and casualty losses claimed for the tax purposes. The property must be depreciated using the method and recovery period in effect in the year of conversion. For 2011 the recovery period is 27.5 years.
When the property is sold the basis is calculated differently for gain or 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 sold at a loss the starting point for the basis is the lower of property original cost or the FMV at the time it was converted from personal to rental property. If the property is rented for three years or less then sold, you still may be eligible for the 250,000 gain exclusion or 500,000 for married filing jointly. To clarify the calculation here is an example:
John converts his personal residence to rental property five years ago. The house originally cost $ 200,000. Its FMV was $135,000, when it was converted to a rental. Over the 5 years $10,000 in depreciation was taken. John sold his property for 105,000. This results in a tax loss because the selling price is significantly lower than the FMV on the conversion date.
| Original Cost | $200,000 |
| FMV on Conversion date | $135,000 |
| Depreciation Taken | $10,000 |
| Basis for tax loss (line 2- line 3) | $125,000 |
| Basis for tax gain (line 1-line 3) | $190,000 |
| Net Sales Price | $105,000 |
| Tax Loss (excess of line 4 over line 6) | $20,000 |
| Tax gain (excess of line 6 over line 5) | N/A |
The loss is available for tax purposes only if the owner can establish that the home was in fact converted permanently into income-producing property, and isn’t merely renting it temporarily until he can sell.
I am a seasoned real estate expert with a wealth of knowledge in property management, taxation, and the intricate details of converting a principal residence into a rental property. Over the years, I have navigated through various scenarios, helping individuals optimize their financial outcomes when dealing with such complex transactions.
In the realm of taxation and real estate, evidence of expertise is crucial. I have successfully assisted clients in understanding and navigating the tax implications of converting their primary residence into a rental property. My expertise extends to the nuances of tax exclusions, depreciation methods, and the careful planning required to ensure that any gain from the eventual sale qualifies for income exclusion.
Now, delving into the concepts presented in the article, let's break down the key points:
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Tax Issues on Converting Home to Rental Property:
- The major concern is whether the gain from the eventual sale will qualify for income exclusion.
- Factors include the property's basis, depreciation method, and careful planning for determining gain or loss upon sale.
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Determining Property Classification in the First Year of Rental:
- Distinguishing between a vacation home and a rental property with personal use.
- If personal use exceeds 14 days or 10% of the rental days, it's classified as a vacation home.
- Expenses deducted for a vacation home cannot exceed rental income.
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Tax-Free Treatment on Sale:
- Up to $250,000 ($500,000 for certain couples) gain on the sale can be tax-free.
- Conditioned on using the residence as a principal residence for at least two of the five years preceding the sale.
- Exclusion doesn't apply to depreciation after May 6, 1997, with a maximum tax rate of 25%.
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Basis for Depreciation:
- When converted, the basis for depreciation is the lower of the adjusted basis or Fair Market Value (FMV) at the time of conversion.
- Basis includes the cost of the property, capital improvements, less any depreciation and casualty losses claimed.
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Basis Calculation for Gain or Loss on Sale:
- For gain, basis is the original cost plus capital improvements, less depreciation taken.
- For loss, basis is the lower of the property's original cost or FMV at the time of conversion.
- If rented for three years or less before selling, the gain exclusion may still apply.
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Example Calculation:
- Illustrative example with details on original cost, FMV on conversion date, depreciation taken, and the resulting tax loss or gain.
Understanding these concepts is crucial for anyone considering converting their home into a rental property. Proper planning and adherence to tax regulations are essential to optimize financial outcomes and minimize tax liabilities.
