How to Calculate Basis of a Primary Residence Converted to Rental Property [Reg. §1.168(i)-4(b)] [Reg. §1.165-9(b)(2)]

How to Calculate Basis of a Primary Residence Converted to Rental Property [Reg. §1.168(i)-4(b)] [Reg. §1.165-9(b)(2)] can be a nuanced and complicated question to answer as it depends on a handful of specific facts and circumstances. Many people have built impressive residential real estate portfolios one property at a time, living in the property while fixing it up thus declaring it their primary residence for income tax purposes and then moving onto a new house to fix up and subsequently rent out, and repeat.

Several of my friends in Colorado, Minnesota and Wisconsin are doing this to one or more homes per year. Good for them!

For those with the tools and the skill set it is a great way to navigate life. For me, I know as a matter of fact my wife would have divorced me 3 time over if this was my calling. She just has a thing about living in a kept up uncluttered house. Nevertheless my friends usually tend to hold on to their properties but every once in a while for one reason or another sometimes they must be sold.

At issue with many of these folks is the fact that there is essentially the equivalent of a 2 year holding period that must be endured before disposition of the property can be considered as rental real estate for capital gain (or loss) purposes. Once that 2 year period is achieved some properties are sold at a gain while others are sold at a loss and the question becomes determining for tax purposes what the gain or loss is.

According to [Reg. §1.168(i)-4(b)]if you have ever converted your primary residence to rental property you need to know that when a personal asset is converted to business or income-producing use, the basis or investment for depreciation is the lower of the adjusted basis on the date of conversion, or the fair market value (FMV) of the property at the time of conversion.

If after the obligatory holding period the converted property is sold at a gain, the basis in the converted property is the original cost plus amounts paid for capital improvements, less any depreciation taken.

However according to [Reg. §1.165-9(b)(2)] if the sale results in a loss the starting point for basis is the lower of the property’s original cost or the fair market value (FMV) at the time it was converted from personal to rental property . This section of the code was drafted in an effort to make sure that any decline in value happening while the property was held as a personal residence before conversion to rental property does not become deductible upon sale of the rental property.

Basically a loss from the sale of converted property is allowed only to the extent the property has declined in value following the conversion and taking into account any depreciation considerations.Essentially what this means is that you could have a situation where no gain or loss is reported because the original cost is used in the gain computation, and the lower of cost or FMV is used for determining loss.I’ve pulled an excellent example of this from the National Association of Tax Professionals web site below.

Taxpayer X “converted her former primary residence to a rental property about three years ago. Her cost basis is $350,000 and the FMV of the property at the time of conversion was $300,000. Approximately, $30,000 of depreciation was taken on the property. She sold the property for $310,000. Does she have a gain or a loss?

With this client’s fact set, basis for determining loss is $270,000 ($300,000-$30,000). Basis for determining gain is $320,000 ($350,000-$30,000). No reportable gain or loss occurs because (1) no gain results when the original cost is used in the gain computation, and (2) no loss results when using the lower of cost or FMV for determining loss.”

At issue is how does one report this on IRS Form 1040 and unfortunately that is why you will need to engage an Enrolled Agent licensed by the US Treasury to practice before the IRS to prepare, sign and file your taxes or defend you upon examination. It is a procedural nuance that only a handful of federally authorized tax practitioners know how to handle.

For more on this contact me directly.