With the crash of the real estate market some are looking to capitalize and purchase larger homes for a bargain price. In doing so, they face the problem of selling their current residence to make the move up. With the lack of buyer interest and with some people not willing to take such a large loss people are holding out for the market to rebound. This creates the problem of carrying two mortgages, which the monthly payments on two mortgages can create cash flow problems for many taxpayers in this situation.
To help with this burden, a taxpayer may decide to rent out their prior residence to help bring in cash and cover the monthly costs on that property. If the tax payer decides to go this route there are a number of rules/guidelines that one has to be aware of.
Rental vs. Vacation Property
The first of these rules (which would only apply to the first year of renting) is determining if the property being rented qualifies as a “rental property” or a “vacation property.” The general rule is if the home was personally used for more than the greater of 14 days or 10% of the days the dwelling is rented for the year it is classified as a vacation home and subject to the rules under code section 280A. The main difference between a rental and vacation property is the expenses that can be deducted. If it is classified as a vacation property the only rental expenses that are deductible is the portion of the year that the property was rented. If it is deemed to be a rental property all expenses are considered business related and possibly deductible. For the sake of this conversation we are assuming that this rule is met and the home qualifies as a rental property.
Depreciable Basis of a Property
After determining the home is a rental property the first step is determining the depreciable basis of the property. When a personal home is converted to business use, the total basis is calculated by taking the lower of the adjusted basis or the fair market value of the property on the date of conversion. If the property was a personal residence and no depreciation was taken for business use of home you should go back to the purchase documents of the home to determine original cost which would also be the adjusted basis. Once the total basis is calculated the land portion is broken out and the remaining portion is considered the depreciable basis. Once the depreciable basis is calculated it must be depreciated using the method and recovery period set by the IRS at the time of conversion (at this time the method to be used is straight line and recovery period is 27.5 years for residential property).
Along with depreciation expense the taxpayer must start keeping records of the income earned and expenses incurred in renting the home. The list of expenses that are deductible for rental properties is longer than that for a personal residence. Many of the costs of renting a home (mortgage interest, real estate taxes, insurance, advertising, repairs and maintenance, supplies, etc.) are deductible.
First Time Home Buyer Credit
If the home was purchased within 2008 or 2009 and the first time home buyer credit was taken on the purchase there may be additional tax consequences to consider. If the home for which the first time home buyer credit is taken is converted to a rental property within 36 months of purchase a portion of the credit will be required to be repaid. This portion will depend on how long the home was used as a personal residence.
Selling the Property
Finally, after a taxpayer converts their former personal residence to rental property and gets to the point that they want to sell it there are more rules to be aware of. First the gain or loss must be calculated, and to do this the basis of the property must again be calculated. The basis can differ depending on if the property is being sold at a gain or a loss. If the property is sold at a gain, the basis of the property is the original cost basis to the taxpayer, plus any amounts paid for capital improvements (capitalized and not previously deducted), less any depreciation taken. If the property is sold at a loss, the basis is the lower of the original cost basis or the fair market value at the date of conversion, plus any capital improvements, less any depreciation taken. Rental property, when sold, is treated as a capital gain/loss but just because it was rented for a short period of time does not completely preclude the taxpayer from taking advantage of the gain exclusion rules for a personal residence. If the property is rented for less than 3 years before being sold, the taxpayer may still be eligible to take a portion of the personal home gain exclusion. This gain exclusion cannot be used against gain from recapture of depreciation though.
Summary
With the current state of the real estate market, renting a prior personal residence may be beneficial for a taxpayer to help wait out the recession and see some of the buyer interest and value come back. If one decides to go this route these are the rules/guidelines that should be considered at each stage of the process.
Contact our CPAs, business and financial advisors in Cleveland or Akron at 440-449-6800 or www.skodaminotti.com.
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1st Home (a duplex used entirely as personal residence now converted in Jan 2010 to rental): Purchased in 2005 at a price of $1,225,000, improvements from 2005-2009=$25,000. Thus a cost basis of $1,250,000.
FMV at time of conversion to rental (Jan 2010): Approximately $1,000,000 to $1,100,000 (there are various studies I can use to justify a price at the lower or higher end of this range).
Improvements since conversion (Feb 2010): $40,000
I understand I need to use the lower of cost of FMV as the basis at the time of conversion to rental. So that means the new basis of the rental should be the $1,000,000-$1,100,000 plus the improvements since conversion for a new basis of $1,040,000 - $1,140,000.
Questions:
1) If in the future I sell what is the basis for the sale? The original cost basis (which is higher) or the new post conversion basis?
2) If the basis at the sale is the lower post conversion basis I am in effect losing the difference between the cost basis and the post conversion basis. How is that amount recouped – or how can it be recouped?
3) Are there any other considerations I should think about in determining to either hold on to it or sell it?
1) If in the future I sell what is the basis for the sale? The original cost basis (which is higher) or the new post conversion basis?
The answer depends on the price for which the property is sold and if that price would create a gain or loss. A key to keep in mind here is as you rent this property you should depreciate every year, which will give you a rental deduction and reduce the basis in the property. See my example below.
Based on the facts stated above and assuming the higher end of the range given, if the property is sold for $2,000,000 in January 2011 this would create a gain. Because there is a gain you would use the original cost basis, plus any improvements, minus any depreciation.
Sale Price - $2,000,000
Original Cost Basis - 1,225,000
Capital Improvements - 40,000
Depreciation Taken - (41,455) (Assumed 1 year of depreciation – $1,140,000 / 27.5 years = 41,455)
Total Basis - 1,223,545
Gain on sale of property - 776,455
Note: if you sell the property within 3 years of converting it from your personal residence to a rental you would be able to claim a portion of the personal home exemption and use that against this gain, therefore reducing the gain and any related tax. Also because there is a gain there are depreciation recapture rules that have to be addressed.
If the property is sold for $900,000 in January 2011 this would create a loss. Because there is a loss the basis would be the lower of the original cost basis or the fair market value at the date of conversion, plus any improvements, minus any depreciation.
Sale Price - $900,000
Lower of Original Cost Basis or FMV - 1,100,000
Capital Improvements - 40,000
Depreciation Taken - (41,455) (Assumed 1 year of depreciation – $1,140,000 / 27.5 years = 41,455)
Total Basis - 1,098,545
Loss on sale of property - (198,545)
2) If the basis at the sale is the lower post conversion basis I am in effect losing the difference between the cost basis and the post conversion basis. How is that amount recouped – or how can it be recouped?
As you can see above if the property is sold and a loss is taken you would use the fair market value at the date of conversion as it is lower than the original cost basis. Unfortunately, this difference cannot be deducted. The IRS rules state that if a personal residence is sold for a loss that loss is not deductible because it is considered a personal expense. Therefore this reduction in basis and amount that was lost is not tax deductible for tax purposes.
3) Are there any other considerations I should think about in determining to either hold on to it or sell it?
As mentioned in the blog posting the biggest factors are the housing market (what can you get for the home) and your willingness to take the role of renting the property (the time and effort demands required). Below are a couple points to consider.
- I am not sure on the location of this property but I would try to determine what the housing market demand will be in the future in the area. Overall, the market is still down and we all know there will be no big rebound to the good old days. But if you think that the demand for this property may increase in a year or two it may be worth renting for that period.
- The other issue I have seen is your reason for moving. If you are moving out of town it may be difficult to oversee renting the property from where you are. In this situation you can consider hiring a property manager or you may choose to sell the house.
- The income from the rental should also be a consideration. Assuming the worst case scenario that money will be lost on the sale of this property, are you able to make money from renting the property? Or at least cover the cost or the property? If you are able to do this it will allow you a more time to wait out the real estate market.
There may be some other factors to consider depending on your personal situation. Also, there are other factors that I would consider depending on what your future investment plans are (if they involve investing in some other form of real estate), but if not these are the main ones to focus on.
If you have any further questions, or would like to carry on this discussion, please feel free to contact me at 440-449-6800.
Thanks-
Dave