Many homeowners have considered becoming a landlord. It’s an attractive option if your local real estate market is surging and rental rates are strong, especially if you’re already thinking about relocation or downsizing from your current home.
In a perfect world, you’ll be able to shelter most or all of your rental income with tax deductions and eventually sell the property for more than you originally paid. It’s important to understand the confusing tax rules that you’ll need to work with when your personal residence is converted into a rental property.
Special Basis Rule
When you become a landlord, you can depreciate the tax basis of the building part of a residential rental property (not the basis of the land) over 27.5 years. In layman’s terms, this means you can deduct a portion of the building’s value/cost every year for the next 27.5 years from your taxable income. However, a special basis rule applies to rental property that was formerly a personal residence.
Under the special rule, the initial tax basis of the building for purposes of calculating your postconversion depreciation write-offs is the lower of:
- The building’s fair market value (FMV) on the conversion date, or
- The building’s regular basis on the conversion date.
Regular basis severally means original cost plus the cost of improvements (excluding normal repairs and maintenance).
When You Sell
Tax rules become particularly confusing when you sell the property. To determine if you have a deductible loss, a similar special basis rule applies. That is, you must use the lower of:
- The property’s FMV on the conversion date, or
- The property’s regular basis on the conversion date.
Additionally, the initial basis must be reduced by depreciation deductions taken during the rental period. The special basis rule and depreciation deductions greatly reduce the odds of having a deductible loss on a sale, especially when property values are below historical levels. Like many areas, our property values are recovering, but that also means the chances of reporting a taxable gain have increased.
Your tax basis for purposes of calculating whether you have a taxable gain on a sale is simply the property’s regular basis on the sale date. Regular basis generally equals the original cost of the land and building, plus the cost of improvements minus depreciation deductions claimed during the rental period.
Sellers in Limbo
When a converted property is sold, you must use the special basis rule to determine if you have a deductible loss on the sale, but you must use the regular basis rule to determine if you have a taxable gain. Following two different basis rules can sometimes cause sellers to have neither a taxable gain nor a deductible loss. This happens whenever the sale price falls between the two basis numbers.
Confused? Here are some examples of how to calculate gains and loss to help clarify.
Example 1: No tax gain or loss on sale
To illustrate how this works, suppose you convert your home to a rental while the market is recovering — but it hasn’t returned to its previous peak by the time you sell. Here’s how the numbers might shake out:
| Regular basis on conversion date | $300,000 | |
| Postconversion depreciation deductions | ($13,000) | |
| ————————- | ||
| Regular basis for tax gain | $287,000 | |
| ————————————————– | ————————- | ————————- |
| FMV on conversion date | $235,000 | |
| Postconversion depreciation deductions | ($13,000) | |
| ————————- | ||
| Special basis for tax loss | $222,000 |
If the net sale price is between $222,000 and $287,000, you have no tax gain or loss, because the sale price falls between the two basis numbers.
Example 2: Modest gain on sale
Alternatively, suppose you convert a property in a market that’s still in the early stages of recovery, and you intend to hang onto it for a while before selling.
| Regular basis on conversion date | $300,000 | |
| Postconversion depreciation deductions | ($32,000) | |
| ————————- | ||
| Regular basis for tax gain | $268,000 | |
| ————————————————– | ————————- | ————————- |
| FMV on conversion date | $285,000 | |
| Postconversion depreciation deductions | ($32,000) | |
| ————————- | ||
| Special basis for tax loss | $253,000 |
If the net sales price is above $268,000, you have a taxable gain. For example, with a net sale price of $345,000, you must report a taxable gain of $77,000 ($345,000 – $268,000). That is because, in this example, the postconversion depreciation deductions reduced the regular basis and the value of the property jumped. As a result, the sale price exceeds the regular basis, which produces a modest taxable gain on the sale.
Example 3: Big gain on sale
Now, let’s suppose you convert a property in a strong market. You’ve owned it for years and its FMV never fell below what you paid for it. In this case, the special basis rule for determining if you have a tax loss does not apply.
| Regular basis on conversion date | $235,000 | |
| Postconversion depreciation deductions | ($26,000) | |
| ————————- | ||
| Regular basis for tax gain | $209,000 | |
| ————————————————– | ————————- | ————————- |
| FMV on conversion date | $285,000 |
Assuming the property is sold for $360,000, your taxable gain would be a whopping $151,000 ($360,000 – $209,000). In this example, the postconversion depreciation deductions reduced the property’s basis and the value jumped after the conversion. So the sales price substantially exceeds the basis, generating a significant taxable gain on the sale.
Principal Residence Gain Exclusion
Fortunately, some landlords may be able to shelter their gain on the sale of a recently converted property with the principal residence gain exclusion. When allowed, the gain exclusion really helps: Unmarried property owners can potentially exclude gains of up to $250,000, and married joint-filing couples can potentially exclude up to $500,000.
Important note: If you qualify for the gain exclusion, you can’t use it to shelter the part of a gain that’s attributable to depreciation deductions. In the previous example, if the gain exclusion applied, the taxpayer must still report a taxable gain of $26,000, which equals the amount of the postconversion depreciation deductions. But that’s much less than the total gain of $151,000.
To qualify for this exclusion, the tax rules require that you use the property as your principal residence for at least two years during the five-year period ending on the sale date. So, it’s impossible to meet the two-year usage requirement once you’ve rented the property for more than three years during that five-year period.
So, this tax break is allowed only if you’ve rented the property for no more than three years after the conversion date at the time you sell.
Ready to Convert?
Home-to-rental conversions can be a lucrative financial proposition for some property owners, especially in a strong market like ours, but the tax rules have the potential to be incredibly confusing. To help understand the rules and evaluate whether you should become a landlord, contact your Crippen & Co. tax advisor. Our team knows the ins-and-outs of these rules and can help you determine what’s best for your specific situation. We consider all the factors that can impact your decision and help you make the right decision for your unique property.