June 15, 2017
Have you ever thought about becoming a landlord? This option may be tempting if your local real estate market is surging and rental rates are strong, especially if you’re already planning to relocate or downsize to a smaller home.
Ideally, you’ll be able to shelter most or all of the rental income with tax deductions and eventually sell the property for a higher price than you originally paid. In the meantime, however, it’s important to understand the confusing tax rules that apply when a personal residence is converted into a rental.
Special Basis Rule
Once 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 plain English, this means you can deduct from your taxable income a portion of the building’s value every year for the next 27.5 years. However, a special basis rule applies to a rental property that was formerly a personal residence.
Under the special rule, the initial tax basis of the building portion of the property for purposes of calculating your postconversion depreciation write-offs equals 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 usually equals original cost plus the cost of any improvements (excluding any normal repairs and maintenance).
When You Sell
The rules become really 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, you must reduce the initial basis by depreciation deductions taken during the rental period. The special basis rule and the depreciation deductions greatly reduce the odds of having a deductible loss on a sale, especially when property values are below historical levels. With property values recovering in many areas, however, 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 any 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:
FMV on conversion date
Postconversion depreciation deductions
Special basis for tax loss
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.