Tax consequences of converting your primary residence to rental property
By Jimmy Forbes, Partner, Tax & Business Services
While the real estate market has been improving, many homeowners may still find their home value is less than their original purchase price. There are many important tax consequences as a result of the conversion.
Once you decide to convert to rental, you will be allowed to depreciate the property over 27.5 years. Depreciation can shelter some or all of your rental income by providing you noncash deductions. Depending on your specific facts, you may be able to use losses from your rental property (including depreciation deductions) to reduce taxable income received from wages, interest and dividends.
The amount you are allowed to depreciate is the lesser the fair market value (FMV) at date of conversion or your original purchase price. For example, if you paid $300,000 for your home several years ago and its fair market value today is now $250,000, you can only depreciate $250,000. Remember, you can only depreciate the building portion of the property, not the land.
If you ultimately sell for less than your original purchase price, the results can unexpected. Below are two examples.
Example 1: You sell the property at less than your original purchase price but more than FMV at date of conversion.
- Regular basis (original purchase price): $300,000
- FMV on conversion date: $250,000
- Post-conversion depreciation deductions: $21,000
- Basis for determining tax loss (line 2 – line 3): $229,000
- Basis for determining tax gain (line 1 – line 3): 279,000
- Selling price: $270,000
- Tax loss (excess of line 4 over line 6): zero
- Tax gain (excess of line 6 over line 5): zero
You end up in “no man’s land” where you have no gain or loss on disposal.
Example 2: If you sell the property at a substantially reduced price:
- Regular basis (original purchase price): $300,000
- FMV on conversion date: $250,000
- Post-conversion depreciation deductions: $21,000
- Basis for determining tax loss (line 2 – line 3): $229,000
- Basis for determining tax gain (line 1 – line 3): 279,000
- Selling price: $170,000
- Tax loss (excess of line 4 over line 6): $59,000
- Tax gain (excess of line 6 over line 5): zero
In this example, your tax loss ($59,000) plus depreciation deduction ($21,000) is $80,000. However, your actual economic loss is $130,000 ($300,000 original purchase price less $170,000 selling price). Your $50,000 “loss” between your original purchase price and FMV at conversion is essential “lost” and not deductible. When you convert the property to rental, it may prove beneficial to get your property appraised to support your valuation at date of conversion. This will help you support that you have a $59,000 tax deductible loss shown in Example 2.
If you ultimately sell the property for a gain, you must use the regular basis for determining the gain. Continuing the example above, if you subsequently sell the property for $375,000, your gain (excluding depreciation recapture) is $75,000.
If you sell your rental property for a gain, can you utilize the exclusion on gain provision? It depends. To qualify for the exclusion of gain on the sale of your principal residence, the property must have been your principal residence for at least two of the last five years. If you have rented the property for more than three years, you will NOT meet the two of last five rule and you may not exclude any portion of the gain from taxable income.
Need help on tax consequences of converting your principal residence to rental property? Contact our Tax Planning and Preparation Group at 440-459-5700 or email [email protected].
