Thanks to today’s record-low interest rates, many homeowners are eyeing replacement principal residences. Despite the inflated home prices their properties may fetch, homeowners are reluctant to take their sale proceeds into today’s high-cost market. They face a frustrating dilemma: sell high, but also buy high.
Clients in this catch-22 have another option: if they qualify to purchase a replacement residence without a contingent sale, they may still be able to squeeze some profit from their current home by converting it to a rental property. But let the owner beware: the tax repercussions may outweigh the benefits of conversion!
As their real estate agent, you must advise these homeowners of the basic rules regarding taxable gains and losses on the sale of rental property.
For federal income tax purposes, a homeowner can exclude up to $250,000 of the gain (up to $500,000 for a married couple) on the sale of their principal residence if they:
- owned the home for at least two years;
- occupied the home as their principal residence for at least two of the past five years; and
- did not exclude gain from the sale of another home during the two-year period ending on the date of the sale. [26 United States Code §121]
If the homeowner sells the property within three years of converting it to a rental, they may still qualify for the principal residence profit exclusion.
In some cases, if they owned and lived in the property as their principal residence for less than two years, they may still be eligible for a “reduced maximum exclusion” if the sale was due to:
- job relocation;
- health reasons; or
- unforeseen circumstances. [USC §121]
Calculating basis for tax gain or loss
In selling a converted property, the basis used to calculate a gain is different from the basis used for determining a loss. Furthermore, the date of conversion applied in determining the basis for depreciation is the date the property’s use was converted from principal residence to rental property for tax purposes.
The basis used for calculating a gain is determined by taking the cost basis (original purchase price + capital improvements – any casualty loss) less any post-conversion depreciation taken.
The adjusted basis for calculating a loss is determined using the lesser of:
- the cost basis on the date of conversion; or
- the fair market value (FMV) on the date of conversion.
Thus, the rule for calculating the adjusted basis prohibits a tax loss from a decline in value that occurs prior to the conversion date. [IRS Pub. 551]
Sell now or later?
Let’s say a principal residence was converted to a rental property four years ago. The owner’s cost basis was $600,000, and the property’s FMV was $580,000 at the time it was converted to a rental. Depreciation taken during the rental period was $36,000. Let’s take a look at what effect three different sales prices would have on taxable gain or loss referencing the chart below.
- Cost basis $600,000
- FMV on conversion date $580,000
- Post-conversion depreciation $36,000
- Adjusted basis for tax loss (line 2 – line 3) $544,000
- Basis for tax gain (line 1 – line 3) $564,000
Example 1: Let’s assume the property now sells for $590,000 (see line six, below). The depreciation taken would actually cause this sale to result in a taxable gain of $26,000 (line eight).
- Net sales price $590,000
- Tax loss (excess of line 4 over line 6) N/A
- Taxable gain (excess of line 6 over line 5) $26,000
Example 2: Let’s say the property sells for $530,000 (line six, below). Since this scenario does not result in a taxable gain, the adjusted basis rule for tax loss purposes results in a loss of $14,000 (line seven).
- Net sales price $530,000
- Tax loss (excess of line 4 over line 6) $14,000
- Taxable gain (excess of line 6 over line 5) N/A
Example 3: We’ll assume the property sells for $560,000 (line six, below). In order to claim a loss, the sales price would have to be less than the adjusted basis (line four). Likewise, to have a taxable gain, the sales price would have to exceed the basis for tax gain (line five). Since the sales price lands between both basis numbers, the result would be no taxable gain or loss.
- Net sales price $560,000
- Tax loss (excess of line 4 over line 6) N/A
- Taxable gain (excess of line 6 over line 5) N/A
Understanding the rules behind these three scenarios will help you guide homeowners in deciding whether to sell or convert their home to rental property. In some cases, taking advantage of the principal residence profit exclusion and selling now versus later can mean tens of thousands of dollars in homeowner savings.
This article was originally posted February 2014 as Brokerage Reminder: Know the basis when converting homes to rentals, and has been updated.
