It is not uncommon to have a client convert a personal residence to a rental property. Some even think if they convert to rental use a home that has declined in value, they can then deduct a loss when they sell the property, which is not the case.
When a residence or other nonbusiness property is converted from personal use to business or income-producing use, for purposes of calculating losses or depreciation (but not gain), the basis for the property on the date of its conversion is the lower of its adjusted basis or fair market value on that date (Regulation Sec 1.167(g)-1).
However, for purposes of computing gain, the basis continues to be the adjusted basis at the time of the conversion (Reg § 1.165-7(a)(5); Reg § 1.165-9(b); Reg § 1.167(g)-1). Thus for property converted from personal use to business use the conversion has created a dual basis for the property:
- For computing a loss: if the sale results in a loss, the basis is the lower of the FMV or the adjusted basis at the time of conversion.
- For computing a gain: if the sale results in a gain, the basis is the adjusted basis at the time of conversion.
A sale of converted property where the sales price is more than the basis for loss but less than the basis for gain results in no gain or loss.
When converting personal use property to business use, the FMV of the property can be a very important factor. If challenged, the IRS will want to know how the FMV was determined and will require more than a guess. They often require a certified appraisal. Taking short cuts can lead to problems in the future.