 Show The first year your property is rented you need to determine whether it is a vacation home or a rental property with personal use. If the personal use exceeds the greater of 14 days or 10% of the number of days during the year the unit is rented, then the property will be classified as a vacation home. If the property is classified as a vacation home the amount of expenses deducted cannot exceed the rental income. You can escape taxation on up to $250,000 ($500,000 for certain married couples filing joint returns) of gain on the sale of your home. However, this tax-free treatment is conditioned on you having used the residence as your principal residence for at least two of the five years preceding the sale. The tax break will not apply to the extent of any depreciation allowable with respect to the rental or business used of the home for the periods after May 6, 1997. A maximum tax rate of 25% applies to this gain. When the property is converted the basis 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. Generally the basis is the cost of the property plus the amounts paid for capital improvements, less any depreciation and casualty losses claimed for the tax purposes. The property must be depreciated using the method and recovery period in effect in the year of conversion. For 2011 the recovery period is 27.5 years. When the property is sold the basis is calculated differently for gain or loss. When the property is sold at a gain the basis is the original cost plus amounts paid for capital improvements, less any depreciation taken. When sold at a loss the starting point for the basis is the lower of property original cost or the FMV at the time it was converted from personal to rental property. If the property is rented for three years or less then sold, you still may be eligible for the 250,000 gain exclusion or 500,000 for married filing jointly. To clarify the calculation here is an example: John converts his personal residence to rental property five years ago. The house originally cost $ 200,000. Its FMV was $135,000, when it was converted to a rental. Over the 5 years $10,000 in depreciation was taken. John sold his property for 105,000. This results in a tax loss because the selling price is significantly lower than the FMV on the conversion date.
The loss is available for tax purposes only if the owner can establish that the home was in fact converted permanently into income-producing property, and isn’t merely renting it temporarily until he can sell. What Is The Tax Treatment When You Sell a Personal Residence That Had Been Converted From Your Principal Residence Into Rental Property? When you sell rental property that had once been your principal residence, tax treatment can get a bit complicated. In particular, you need to pay attention to the issues of losses, depreciation, and adjusted tax basis. You cannot deduct any loss you realize upon the sale of a home used wholly as your primary residence or second home. However, if the home is converted to rental use prior to the sale, you may be able to deduct a portion of the loss. How Do You Compute The Tax Basis of a Personal Residence Converted to Rental Property? In general, the adjusted tax basis of a personal residence is the cost of the property (i.e., what you paid for the property when you first purchased it), plus amounts paid for capital improvements, less any depreciation and casualty losses claimed for tax purposes. (Improvements add value to the home, prolong its life, or adapt it to a new use. Note that regular repairs and maintenance are not included in the adjusted tax basis of the home.) When a personal residence is converted to rental property, you need to know its basis for depreciation purposes. Its basis for depreciation purposes is the lower of:
What Depreciation Method Is Used? Federal law provides that any real property acquired before 1987 and converted to rental or business use after 1986 is subject to the Modified Accelerated Cost Recovery System (MACRS). In general, you must depreciate your residential rental property over a 27.5-year period.
How Do You Calculate The Capital Gain or Loss on The Subsequent Sale of Converted Property? In order to calculate the capital gain or loss when you sell a residence that had been converted to rental property, you need to know three things:
If the converted property is later sold at a gain, the basis for purposes of determining the capital gain is your adjusted tax basis in the property at the time of the sale. If the sale results in a loss, however, basis is the lower of the property's adjusted tax basis at the time of the conversion or the fair market value when the property was converted from personal use to rental property. This loss rule ensures that any deflation in value occurring while the property was held as a personal residence does not later become deductible upon your sale of the rental property, a loss on the sale of a personal residence is not deductible. As usual, you calculate your capital gain by subtracting your adjusted basis from the sale price of the property. Example(s): Assume Ken converted his personal residence to income-producing property ten years ago. The house had an adjusted tax basis of $50,000 and was worth $60,000 when it was converted to rental use. Over the 10-year rental period, Ken deducted a total of $9,000 in depreciation expense. Ken sells the property for $65,000. His capital gain is computed as follows:
Caution: You’re holding period for converted property (for purposes of capital gain or loss) begins on the date that your property was acquired--not on the conversion date. This material was prepared by Broadridge Investor Communication Solutions, Inc., and does not necessarily represent the views of The Retirement Group or FSC Financial Corp. This information should not be construed as investment advice. Neither the named Representatives nor Broker/Dealer gives tax or legal advice. All information is believed to be from reliable sources; however, we make no representation as to its completeness or accuracy. The publisher is not engaged in rendering legal, accounting or other professional services. If other expert assistance is needed, the reader is advised to engage the services of a competent professional. Please consult your Financial Advisor for further information or call 800-900-5867. The Retirement Group is not affiliated with nor endorsed by fidelity.com, netbenefits.fidelity.com, hewitt.com, resources.hewitt.com, access.att.com, ING Retirement, AT&T, Qwest, Chevron, Hughes, Northrop Grumman, Raytheon, ExxonMobil, Glaxosmithkline, Merck, Pfizer, Verizon, Bank of America, Alcatel-Lucent or by your employer. We are an independent financial advisory group that specializes in transition planning and lump sum distribution. Please call our office at 800-900-5867 if you have additional questions or need help in the retirement planning process. The Retirement Group is a Registered Investment Advisor not affiliated with FSC Securities and may be reached at www.theretirementgroup.com.
Tags: Financial Planning, Lump Sum, Pension, Retirement Planning When property is converted from personal use to business use what is the basis for depreciation?If you convert personal property to business use, the basis will be the lower of: the fair market value at the time of the conversion, or. the cost plus any additions or improvements, and minus any deducted casualty losses, up to the time of the conversion.
How can depreciation recapture be avoided?Investors may avoid paying tax on depreciation recapture by turning a rental property into a primary residence or conducting a 1031 tax deferred exchange. When an investor passes away and rental property is inherited, the property basis is stepped-up and the heirs pay no tax on depreciation recapture or capital gains.
How do you record gain on sale of rental property?Report the gain or loss on the sale of rental property on Form 4797, Sales of Business Property or on Form 8949, Sales and Other Dispositions of Capital Assets depending on the purpose of the rental activity.
How does depreciation recapture work?“Depreciation recapture” refers to the Internal Revenue Service's (IRS) policy that an individual cannot claim a depreciation deduction for an asset (thereby reducing their income tax) and then sell it for a profit without “repaying the IRS” through income tax on that profit.
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Personal residence converted to rental property and then sold at a gain
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