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Global Tax Insights

Converting a Personal Residence to a Rental Property

June 20, 2017

Converting your personal residence (that you’re selling) to a rental property could be a good way to generate cash flow while you work to sell it.

If you’re planning on moving but having a hard time selling your primary home, you may consider turning your residence into a rental property and buying another place to occupy. If rental prices are soaring in your area, it could be a good way to generate cash flow while you wait for the market prices to rise. There are a number of confusing tax rules to consider; careful thought and tax planning could yield some significant benefits.

Will your sale qualify for a special exclusion from income?

This is the biggest issue to consider. The IRS allows for an exclusion from taxation on up to $250,000 ($500,000 for married couples filing jointly) of the gain on the sale of your home. To be eligible for this treatment, the home has to have been your principal residence for at least two of the five years immediately preceding the sale. (See our related blog on this topic).

Assuming you met this definition before conversion, once the property is rented, the clock starts to countdown until you are no longer allowed to take the exclusion if you did not live in the home for the requisite period. If you are expecting a significant gain upon the sale of the property, it is very important to make sure you consider the timeline to qualify for the gain exclusion. Keep in mind, this tax break will not apply to the extent of any depreciation you were allowed with respect to the rental property. The depreciation will be “recaptured” and taxed at a maximum rate of 25%.

Am I eligible to depreciate?

When you convert the property, you are eligible to depreciate the tax basis of the building portion (not the land) over 27.5 years. Depreciation is a great way to offset rental income without actually expending any additional cash.

Special tax basis rule

When calculating depreciation, there is a special tax basis rule that applies to a rental property that was previously a personal residence. The tax basis for determining the annual depreciation write-off equals the lesser of:

  1. The building’s fair market value (FMV) on the conversion date or
  2. The building’s original basis on the conversion date. Original basis is usually what you paid for the property plus the cost of any improvements (not counting normal repairs and maintenance).

If the FMV of the building on the date of conversion is lower than the original basis amount, you must use the lower FMV amount as the tax basis in computing annual depreciation deductions. This will result in lower annual deductions but if you’re planning to sell in the shorter term, that means potentially less “recapture” on the sale and a higher ending basis.

What happens when the property is ultimately sold?

When the property is ultimately sold, the tax basis is determined differently based on whether it is sold at a gain or a loss.

When 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, basis is the FMV at the time is was converted to a rental property less any depreciation taken. This rule may land you in a weird situation in the middle where you have neither a gain nor a loss on the sale of the property. This happens if the sales price lands between the two basis numbers. In this case, you have no taxable gain and no deductible loss.

Example:

Joe converted his personal residence to a rental property ten years ago. He originally paid $500,000 for the home. When converted to a rental, the property’s FMV was $460,000. A total of $20,000 of depreciation was taken on the property while being rented. Joe now sells the property for $410,000. This results in a tax loss because the selling price is lower than the FMV on the conversion date.

Joe's Example Dollar Amount
Original Cost $500,000
FMV on Conversion Date $460,000
Depreciation Taken $20,000
Basis for Tax Loss (line 2-line 3) $440,000
Basis for Tax Gain (line 1-line 3) $480,000
Net Sales Price $410,000
Tax Loss (excess of line 4 over line 6) $30,000

If Joe had sold the property for $520,000, he would realize a tax gain.

Joe's Example Dollar Amount
Basis for Tax Gain (line1-line 3) $480,000
Net Sales Price $520,000
Tax Gain (excess of line 4 over line6) $40,000
  • If the property was sold for an amount in between $440,000 and $480,000, there would be no tax gain or loss on the sale.
  • Remember, if the property was rented for less than three years and it was your principal residence for at least the two years prior to conversion, you may be eligible for the exclusion on the gain.

There are a number of other nuances to the tax law surrounding rental properties and the conversion of a home to a rental property. It is important to discuss with your tax advisor before pulling the trigger on a transaction to see if there is a better way to structure it. The more facts and accurate timeline you can provide, the more options you will have when weighing your decision. This is certainly a situation where you don’t want to let the tax tail wag the dog, but if one or two small changes to the circumstances are made, it could net you significant tax savings.

Reach out to our Tax Services Team for more info.

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