Please see prior blog regarding the Tax Treatment for Sale of Rental. This blog will dive into the cost basis to use on the sale of a personal residence that was converted to a rental property.
There are special rules regarding the cost basis that is used for a personal residence that is converted to a rental. The tax basis for determining the annual depreciation when the rental is first setup is the lesser of:
- The building’s fair market value (FMV) on the conversion date or
- The building’s original basis on the conversion date. Original basis is usually what you paid for the property plus the cost of any improvements (not counting normal repairs and maintenance).
For example, if you purchased your personal residence in a high real estate market and it later dropped in value when you converted it to a rental, you would use the lower current fair market value to calculate your annual depreciation. You do not want to forget about your original higher purchase price as it comes into play when you sell the property.
When you sell the property, it doesn’t seem right to use the lower market value as cost basis to calculate the gain when you may have purchased the property for much more and your gain would therefore be much less. There is a tax rule to address this inequity.
When sold at a gain, the basis is the original cost plus amounts paid for capital improvements, less any depreciation taken. Pretty straight forward. However, if the sale results in a loss, the basis is the lower of the property’s adjusted tax basis at the time of the conversion or the fair market value of property when it was converted from personal use to a rental.
If you ultimately sell for less than your original purchase price, the results can unexpected. Below are two examples.
Example 1: You sell the property at less than your original purchase price but more than FMV at date of conversion.
- Regular basis (original purchase price): 400,000
- FMV on conversion date: $350,000
- Post-conversion depreciation deductions: $33,000
- Basis for determining tax loss (line 2 – line 3): $317,000
- Basis for determining tax gain (line 1 – line 3): 367,000
- Selling price: $360,000
- Tax loss (excess of line 4 over line 6): zero
- Tax gain (excess of line 6 over line 5): zero
You end up in “no man’s land” where you have no gain or loss on disposal.
Example 2: If you sell the property at a substantially reduced price:
- Regular basis (original purchase price): $400,000
- FMV on conversion date: $350,000
- Post-conversion depreciation deductions: $33,000
- Basis for determining tax loss (line 2 – line 3): $317,000
- Basis for determining tax gain (line 1 – line 3): 367,000
- Selling price: $260,000
- Tax loss (excess of line 4 over line 6): $57,000
- Tax gain (excess of line 6 over line 5): zero
In this example, your tax loss is $57,000. However, your actual economic loss is $140,000 ($400,000 original purchase price less $260,000 selling price). Your $50,000 “loss” between your original purchase price and FMV at conversion is essential “lost” and not deductible, considered a personal nondeductible loss. When you convert the property to rental, it may prove beneficial to get your property appraised to support your valuation at date of conversion. This will help you support that you have a $57,000 tax deductible loss shown in Example 2.
It is wise to evaluate the gains and/or losses on selling a rental property and talk to a tax professional to discuss the best options to maximize your profits before putting it on the market to sale. We are here to help, don’t hesitate to contact our office with any questions or concerns.