Tax Rules that Apply to Home-to-Rental Conversions

Residential real estate values have fully recovered in many areas, and rental rates are strong. To take advantage of this favourable situation, consider buying a new residence and converting your current home into a rental property that you can sell later for a higher price. This strategy can be a tax-savvy move, but it’s not right for everyone. Here are some important tax issues to consider.

Calculating the Tax Basis of a Converted Property

An important question that arises when you convert a personal residence into a rental is how to determine the property’s tax basis for depreciation purposes during the rental period and for gain or loss purposes when you eventually sell. Two different basic rules apply.    

1. For gain on sale purposes. The normal rule for computing the tax basis of a converted property for tax gain purposes is straightforward. The property’s basis usually equals the original purchase price plus the cost of improvements minus any depreciation. This includes depreciation claimed 1) from having a deductible home office while you lived there, and 2) after you convert the property into a rental.    

2. Rules for depreciation and loss on sale purposes. You can’t claim a tax loss when you sell a personal residence for less than tax basis. The privilege of claiming tax losses is reserved for sales of business or investment property.

There’s a common misconception that, if you convert a residence into a rental and then sell it for a loss down the road, you can claim a tax loss on the sale. Unfortunately, a special and unfavourable tax basis rule prevents many taxpayers from claiming losses in this situation.

Under the special rule, the tax basis of a converted personal residence for tax-loss purposes equals the lesser of:

• The property’s normal tax basis on the conversion date (as explained above), or
• The property’s fair market value (FMV) on the conversion date. 

As stated earlier, the property’s normal tax basis usually equals the original purchase price plus the cost of improvements minus any depreciation claimed over the years. This special basis rule is intended to disallow a loss from a decline in value that occurs before the conversion date. But a further decline in value after the conversion can result in an allowable tax loss when you sell the property. However, basis reductions from post-conversion depreciation deductions can offset any post-conversion decline in value.    

You must use the same unfavourable special basis rule to determine your initial tax basis in the converted property for purposes of calculating depreciation deductions during the rental period. You can depreciate the basis allocable to the building — not the portion that’s allocable to the land — over 27.5 years using the straight-line method.

In most areas, the odds of selling a property for a loss today are much lower than a few years ago, when real estate prices were in the doldrums. And the odds that the value of your property will decline after you’ve converted it into a rental may be even lower. But if the property’s value continues to drop, converting sooner rather than later will produce better tax results for you under the special basis rule.  

Evaluating the Tax Results of a Sale

The special basis rule used for tax-loss purposes is different from the normal basis rule used for tax gain purposes. As a result, you can easily wind up selling the converted property for a price that results in neither a tax loss nor a tax gain. This happens if the sale price falls between 1) the basis number used for tax-loss purposes, and 2) the basis number used for tax gain purposes. Consider these examples.

Taxpayer A: no tax gain or loss on the sale. Taxpayer A converted his home into a rental, and now he plans to sell it. His tax advisor has helped him calculate the basis of the property under the two tax rules. The results:

The basis for Gain Purposes

 

Taxpayer A doesn’t have a gain on the property sale, because his basis for tax gain purposes ($383,000) is higher than the net sale price ($380,000).

The basis for Loss Purposes

 

Taxpayer A also can’t claim a loss on the property sale, because his basis for tax-loss purposes ($283,000) is below the net sale price ($380,000). Because the sale price is between the two basis amounts, Taxpayer A doesn’t have a tax gain or a loss on the sale.

Taxpayer B: tax gain on sale. Taxpayer B converted her home into a rental and now plans to sell it. Her tax advisor has helped her calculate the tax basis of the property. The results:

Basis for Gain Purposes

 

Taxpayer B has a $22,000 gain on the sale of the property, because her basis for tax gain purposes ($378,000) is less than the net sale price ($400,000). In this case, her postconversion depreciation deductions caused a tax gain.

Important: If you sell a former principal residence within three years after converting it into a rental, the federal home sale gain exclusion break will usually be available. Under that break, you can shelter up to $250,000 of taxable gain ($500,000 if you’re married). However, you can’t shelter gain attributable to depreciation, including depreciation claimed after you convert the property to a rental. 

Taxpayer C: Tax loss on sale. Taxpayer C converted his home into a rental, and now he plans to sell it. His tax advisor has helped him calculate the tax basis of property. The results:

Basis for Loss Purposes

 

Taxpayer C can claim a $15,000 loss on the property sale, because his basis for tax loss purposes ($315,000) is higher than the net sale price ($300,000). In this situation, the FMV of the property continued to fall after the conversion date. However, this may be an unlikely outcome in current market conditions.

Deferring Taxes with a Section 1031 Exchange 

The tax law allows rental real estate owners to sell appreciated properties and then defer the federal income hit indefinitely. This strategy is commonly known as a like-kind exchange under Internal Revenue Code Section 1031.

With a Sec. 1031 exchange, you swap the property you want to unload for another property (the replacement property). You’re allowed to defer paying taxes until you sell the replacement property. Or when you’re ready to unload the replacement property, you can arrange another Sec. 1031 exchange and continue deferring taxes.

The Sec. 1031 exchange rules give you flexibility when selecting replacement properties. For example, you can trade holdings in one area for properties in more-promising locations. You could also swap an expensive single-family rental house for a small apartment building, an interest in a strip shopping center or even raw land. 

Need Help?

Converting a personal residence into a rental property triggers some tricky tax rules. If you have questions or want more information about these issues, consult your tax advisor. 

Tax Rules for Landlords Once you’ve converted a former personal residence into a rental, you must follow the tax rules for landlords. Here’s a summary of the most important things to know.   Writing Off Business Expenses You can deduct mortgage interest and real estate taxes on a rental property. You can also write off all the standard operating expenses that go along with owning a rental property, such as utilities, insurance, repairs and maintenance, yard care and association fees. In addition, you can depreciate the tax basis of a residential building for over 27.5 years. For example, let’s say the tax basis of your rental property (excluding the land) is $400,000. Your annual depreciation deduction is $14,545 ($400,000 ÷ 27.5 years). So, the property can have that much in positive cash flow without triggering any income taxes. Reporting Taxable Income Rental property generates taxable income when the rents surpass deductible expenses. Of course, you must pay income taxes on those profits. Important note: Taxable income from rental real estate isn’t subject to the self-employment (SE) tax that applies to most other unincorporated profit-making ventures. The SE tax rate can be up to 15.3%.  Avoiding the Unfavorable PAL Rules Rental property generates a tax loss when deductible expenses surpass rents. If your property generates a tax loss, the so-called passive activity loss (PAL) rules will usually apply. In general, the PAL rules allow you to deduct passive losses only to the extent that you have passive income from other sources, such as income from other rental properties or gains from selling them. Passive losses in excess of passive income are suspended until you either have passive income or you sell the property or properties that produced the losses. As a result, the PAL rules can postpone rental property loss deductions, sometimes for many years. Fortunately, there are several exceptions to the PAL rules that can allow you to deduct losses sooner rather than later. Your tax advisor can fill you in. Also, be aware that passive income from rental real estate, as well as any gains from selling rental properties, may be hit with the 3.8% net investment income tax (NIIT). However, the NIIT only hits people in higher tax brackets. Consult your tax advisor for more information about the tax issues that apply to landlords.