Understanding the Tax Rules When Selling a Rental Conversion at a Loss

Kathy Z. Jeziorski, CPA

In recent years, a wave of homeowners have converted their personal residences into rental properties. The reasons for this trend can vary; however, one potentially misguided motivation is the belief that doing so will enable them to claim a tax loss on a property that has declined in value.

It is true that taxpayers are not permitted to claim a tax loss on the sale of their principal residence. However, they may not be fully aware of the limitations imposed by tax laws on the amount of loss that can be claimed when a converted rental property is sold at a substantial loss. This newsletter provides essential information for those considering converting their home to a rental property due to declining property values, with the aim of claiming a tax loss in the future.

Do You Have a Tax Loss?

While you cannot claim a loss on the sale of your home, it is possible to claim a loss on the sale of investment property, which is why converting a home that has fallen in value into a rental property before selling it may be appealing. However, special tax rules might mean you will not receive as large of a tax loss as anticipated, or any at all. It is not simply a matter of deducting the original purchase price from the subsequent sale price.

Taxable gains and losses on the sale of assets are generally calculated by comparing the asset’s sale price to its tax basis. The tax basis for an investment property typically equals the purchase price paid for the property plus the costs of improvements, less any depreciation deductions claimed on it.

The calculation differs when a personal residence is converted into a rental property. In this case, the tax basis of the rental property is the lesser of:

• The normal tax basis on the date of the conversion (purchase price plus improvements less depreciation deductions taken before the conversion); or
• The property’s fair market value (FMV) on the conversion date.

If the FMV is below the normal tax basis on the conversion date, the taxable loss on a subsequent sale will be calculated based on the FMV at that time. Thus, a loss on any drop in the property’s value that occurred before the conversion cannot be claimed. The loss is limited to post-conversion value reductions. Furthermore, when calculating the tax loss, the basis must be reduced by any depreciation deductions claimed post-conversion, making it more challenging to incur a taxable loss.

For example, say, at the time of conversion, your property has a cost basis of $450,000 but an FMV of $350,000. You later sell the property for $310,000, having claimed $15,000 in depreciation deductions post-conversion. You might think you can deduct a loss of $140,000 ($450,000-$310,000) or at least $125,000 (after the reduction for the depreciation deductions) — but you would be wrong.

Your basis for tax loss purposes would be $335,000 ($350,000 FMV less $15,000 in depreciation deductions). The deductible loss would be limited to $25,000 ($335,000 tax basis less $310,000 sale price).

Regarding depreciation recapture, depreciation deductions are recaptured as ordinary income if the property is later sold at a tax gain. Recapture is not a concern if a tax loss is sustained on the sale.

It should be noted that the limited loss in the above example would only be available if the home was genuinely converted into income-producing property, rather than being temporarily rented out with an anticipated sale. A long-term lease typically indicates conversion to income-producing property. However, there have been Tax Court cases where shorter rental periods were deemed valid conversions. For instance, the court found a former residence had been converted to rental property even though it was rented for only three months before sale, resulting in a small net profit after depreciation. Conversely, the court ruled against a taxpayer who rented their residence for a short period for an insignificant amount of money.

Another notable case involved a residence occupied by the taxpayer and their family for 12 years, which was not considered income-producing property despite being rented for 12 months following failed attempts to sell. The Tax Court considers various facts and circumstances in determining whether a former residence was legitimately converted to income-producing property.

How Can You Use the Loss?

A loss on an investment property is considered a capital loss, which can only be used to offset capital gains. If your capital losses for the tax year exceed your capital gains, you can typically claim a capital loss deduction of up to $3,000 per year against ordinary income. Any excess losses can be carried forward to future years. Different rules apply if the activities related to the rental rise to the level of a trade or business.

What If the Home Sells for a Gain?

If you sell the property for a gain, different regulations will apply. The tax gain is calculated based on the property’s normal tax basis as of the conversion date, ignoring the fair market value. Converting the property to a rental may impact your eligibility for the home sale gain exclusion, and depreciation recapture must be considered.

The tax consequences of selling converted rental property are complex. We are available to assist you in determining the most effective strategy.

For more information, please contact Kathy Jeziorski at [email protected] or 312.670.7444. Visit ORBA.com to learn more about our Real Estate Group.