As tax preparers, understanding the nuances of basis adjustments when converting a primary residence into a rental property is crucial.
Determining the Basis for Depreciation:
When a homeowner decides to convert their main home into a rental property, it initiates a change in the property's tax treatment. The basis for depreciation will be the lesser of the property’s fair market value (FMV) or the adjusted basis on the date of conversion. Here's how it works:
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Fair Market Value (FMV) - This is the price at which the property would change hands between a willing buyer and seller. Sales of similar properties around the same date provide a helpful benchmark.
- Adjusted Basis - This includes the original cost of the property plus any permanent improvements, less any casualty or theft losses previously claimed.
Example: Suppose a homeowner originally purchased a residence for $140,000, incurred $28,000 in improvements, and claimed $4,000 casualty loss deduction. The adjusted basis would be $164,000. If the FMV on the conversion date is $147,000, then the depreciation will be based on the FMV of $147,000 (less the value of the land), as it is lower than the adjusted basis.
Dual Basis for Determining Gain or Loss:
Once a home is converted into a rental property, it will have two bases for tax purposes—one for determining gain and one for determining loss upon sale.
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Gain Basis - If the property is sold for more than its adjusted basis, gain is calculated using the original adjusted basis without considering any depreciation taken for the rental period.
- Loss Basis - If the property is sold for less than its FMV at the conversion date, loss is calculated using the FMV on the conversion date.
This distinction is essential, especially when considering future sales of the rental property. Tax preparers must meticulously track these bases to ensure accurate tax reporting.
Section 121 Gain Exclusion Eligibility:
Let’s not forget the valuable Section 121 exclusion. Even if the property is a rental at the time of sale, the homeowners may exclude gains up to $250,000 ($500,000 for married couples) if they meet the two out of five years ownership and use test:
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Ownership Test - The homeowner must have owned the property for at least two years during the five years preceding the sale.
- Use Test - The homeowner must have lived in the property as their main home for at least two out of the past five years preceding the sale.
It’s noteworthy that any depreciation claimed after May 6, 1997, cannot be excluded under Section 121. This is a crucial element for calculating the gain exclusion accurately.