What is the tax treatment when you sell a personal residence that had been converted from your principal residence into a rental property?
When you sell a rental property that had once been your principal residence, tax treatment can get a bit complicated. In particular, you need to pay attention to the issues of losses, depreciation, and adjusted tax basis. You cannot deduct any loss you realize upon the sale of a home used wholly as your primary residence or second home. However, if the home is converted to rental use prior to the sale, you may be able to deduct a portion of the loss.
How do you compute the tax basis of a personal residence converted to a rental property?
In general, the adjusted tax basis of a personal residence is the cost of the property (i.e., what you paid for the property when you first purchased it), plus amounts paid for capital improvements, less any depreciation and casualty losses claimed for tax purposes. (Improvements add value to the home, prolong its life, or adapt it to a new use. Note that regular repairs and maintenance are not included in the adjusted tax basis of the home.) When a personal residence is converted to rental property, you need to know its basis for depreciation purposes. Its basis for depreciation purposes is the lower of:
- Your adjusted basis in the residence on the date of conversion, or
- The fair market value of the property at the time of conversion
What depreciation method is used?
Federal law provides that any real property acquired before 1987 and converted to rental or business use after 1986 is subject to the Modified Accelerated Cost Recovery System (MACRS). In general, you must depreciate your residential rental property over a 27.5-year period.
How do you calculate the capital gain or loss on the subsequent sale of the converted property?
In order to calculate the capital gain or loss when you sell a residence that had been converted to rental property, you need to know three things:
- Your adjusted basis in the property (both at the time of conversion and at the time of the sale of the property)
- The sale price
- The fair market value of the property when it was converted to rental property
If the converted property is later sold at a gain, the basis for purposes of determining the capital gain is your adjusted tax basis in the property at the time of the sale. If the sale results in a loss, however, basis is the lower of the property’s adjusted tax basis at the time of the conversion or the fair market value when the property was converted from personal use to rental property. This loss rule ensures that any deflation in value occurring while the property was held as a personal residence does not later become deductible upon your sale of the rental property, a loss on the sale of a personal residence is not deductible.
As usual, you calculate your capital gain by subtracting your adjusted basis from the sale price of the property.
Example(s): Assume Ken converted his personal residence to income-producing property ten years ago. The house had an adjusted tax basis of $50,000 and was worth $60,000 when it was converted to rental use. Over the 10-year rental period, Ken deducted a total of $9,000 in depreciation expense. Ken sells the property for $65,000. His capital gain is computed as follows:
- Original cost = $50,000
- FMV at conversion = $60,000
- Depreciation taken = $9,000
- Adjusted basis for determining gain (#1 minus #3) = $41,000
- Adjusted basis for determining loss (lesser of #1 or #2 minus #3) = $41,000
- Sales price = $65,000
- Capital gain = $24,000
Caution: Your holding period for converted property (for purposes of capital gain or loss) begins on the date that your property was acquired–not on the conversion date.