Renting Your Home: Feasible
Tax Strategy?
Thinking of renting your home because of
the nondeductible loss on its
sale on your tax return?
One cannot deduct a loss on the sale of one's home on one's personal
tax
return; one can, however, deduct a loss on the sale of investment or
rental property. There has been some discussion appearing on the
internet lately about the possibility of converting one's residence to
rental property in order to deduct the loss on the sale of the
property. The problem with this strategy is that upon the date of
conversion, the tax basis of the rental property is the lower of the
adjusted basis of the residence or its current fair market value.
Since the loss in value of one's home has already occurred before the
date of conversion and would already be reflected in its fair market
value, that loss would still not be deductible on a subsequent sale of
the rental property. On the other hand, if property values
continue to fall in one's geographic area, the portion of that loss
below the adjusted basis of the rental property would be deductible on
a sale. For that to be realized, the average decline in property
values would have to exceed the annual depreciation rate of 3.64% per
year since rental property is depreciated on a straight-line basis over
27.5
years. Is the conversion of residential to rental property really
a feasible tax strategy after all? Before attempting to address
that question, consider the following requirements in order for the
conversion's fair market value to be recognized by the Internal Revenue
Service.
First, one must actually rent the residence and not merely list or
advertise it for rent. The IRS is not easily persuaded by one's
intention on a tax matter. Secondly, one must rent the home or
condo for more than a year. Renting it for one year or less in
all likelihood would be construed by
the Internal Revenue Service as a temporary absence, with the IRS
asserting that it is still one's principal residence. Thirdly, in
order to substantiate the fair market value of the rental property, at
the very least one must obtain a credible market valuation from a
realtor, or better yet, an appraisal from a professional.
How long to rent the property depends on market conditions, cash flow
requirements of the owner, and many other factors too numerous to list
here. However, if the property is sold more than three years
after the date of conversion, any gain excludible under Section 121 as
a sale of
one's principal residence would be taxable since one is required to use
the home as one's principal residence for at least two of the five
years before the sale. Consequently, if the housing market were
to rebound upward sharply, it might be advantageous from strictly a tax
perspective to sell the property within three years of the date of
conversion.
Now to return to the main question of this article: does it make
tax sense to convert residential to rental property after a sharp
decline in market values? There are three possible scenarios of
future housing values: market values rebound; market values
continue to decline; market values stabilize. In order to address
this question, let's examine the tax consequences of a conversion
occurring in these three different market conditions in the order
listed above.
Assume a married
couple purchased a condo several years ago for
$525,000. They now wish to sell it because of an employment
opportunity in another location, and were offered a market
valuation of their home by a real estate agent for $470,000.
After they pay the real estate agent and all selling expenses, they
estimate a total loss on
the sale of their home of $85,000, which is not deductible on their tax
return. They believe that the real estate market has bottomed in
their geographic area and that if they wait a couple of years to sell
their condo, that they will not incur any loss on its
disposition. What are some of the tax ramifications of pursuing a
rental of the residential property for two years (in order to cover
some, if not all, of the carrying costs), and then selling it?
Rental property is depreciated on a straight-line basis over 27.5
years; consequently, if they rent the house for two years, deductible
depreciation expense would be nearly $35,000 in total for the
period. As "active participants" in rental property, they are
allowed to deduct losses of as much as $25,000 per year. In order
to
keep the illustration as simple as possible, assume that they have
incurred an average annual net loss of $17,500 on the renting of their
condo. Consequently, they have received $35,000 in tax deductions
over the two years, reducing their tax liability on their previously
filed tax returns. Now assume after two years, the real estate
market has
rebounded sharply and that they sell the property for $560,000,
incurring
selling expenses of $35,000, netting $525,000 to themselves.
Although the basis of their property had been reduced to $435,000 from
depreciation, of the $90,000 gain on the sale, only the Unrecaptured
Section 1250 $35,000 portion of the gain attributable to the claimed
depreciation (deducted by them on current and prior tax returns) is
taxable; the remaining $55,000 is an excluded gain from sale of
principal residence under Section 121. They are entitled to
exclude this portion of the gain under Section 121 because it is
assumed they have met its three essential criteria:
- They owned the condo for at least two of
the five years before the sale;
- Both used the condo as their principal residence
for at least two of the five years before the sale; and
- Neither
is ineligible for the full exclusion
because of the once-every-two-year limit (i.e., neither claimed the
exclusion of gain on the sale of another residence within two years of
the sale of this condo.)
Notice
that the recognition of all previously claimed depreciation as
ordinary income essentially reverses all previous tax benefits of
expensing depreciation against rental income: i.e., it's a
wash. But the conversion to rental property allows the couple to
deduct holding costs of the condo otherwise not deductible as a
residence while awaiting a market turnaround: e.g., repairs and
maintenance, condo fees, utilities, insurance, commissions,
advertising, auto and travel, legal and professional, cleaning,
supplies, etc.
Now
assume that the housing market does not rebound but continues to
decline in their area, and after a couple of years they sell the condo
for $410,000 after selling expenses. What are their tax
implications of a continued slide in the housing market after the
conversion from residential to rental property? Of the $60,000
loss since the conversion, $35,000 of that would not be deductible as a
loss on the sale because it would have been deductible as depreciation
of the rental property; the remaining $25,000 would be deductible on
their current tax return as an ordinary loss. Therefore, the
entire $60,000 additional loss in value on the condo would be deducted
on their tax returns either as depreciation or loss on the sale of the
rental property. Hence, the conversion to rental property
functions as a limited hedge to additional losses from further declines
in market value when holding property in anticipation of a market
rebound. And, as in the previous example, the rental activity
allows the deductibility of otherwise non-deductible holding expenses.
Now assume that after two years the housing market does not rebound nor
continue to slide but remains the same, and they sell the condo for its
conversion value of $470,000, less selling expenses of $30,000.
Of the $35,000 in depreciation that they had deducted, only $5,000
would be taxable income in the year of sale, since their net proceeds
after selling expenses exceeds the adjusted basis of the property by
$5,000. Hence, the couple receives $30,000 in net depreciation
deductions as well as additional holding expense deductions from the
rental activity to offset against their taxable income.
What conclusions can one draw about the tax ramifications of renting
property for a couple of
years before selling it, following a precipitous decline in market
values? If the market were to rebound, renting would allow the
tax deductibility of virtually all holding expenses, except
depreciation, while preserving the exclusion
under Section 121 of any gain from taxation on its sale. If the
market were to stabilize, virtually all holding costs, including most
if not all of depreciation, would remain tax deductible. And if
the market were to decline, in addition to allowing all holding
expenses to be deductible, the conversion would hedge some of the
additional losses in market values in the form of tax deductions.
Needless to say, if one feels that the market is unlikely
to rebound within the next few years, it might be best to sell rather
than rent at all. However, if one feels strongly about the
prospects of a recovery in the immediate future, converting one's
residence to rental property for a couple of years might very well be a
viable tax strategy: any gain on its sale would still be
excludible
under Section 121; depreciation deductions and deductible losses on the
sale would mitigate the bite of further declines in market values; and
virtually all
holding costs would become tax deductible. All in all, it appears
that one is better off tax wise by converting one's residence to rental
property if one has adopted a holding strategy of one's residence for
two to three years in hopes of a turnaround in market conditions.
These examples ignore many important variables which should be included
in any decision to rent or sell, such as possible depreciation in the
sales value of the residence from the additional wear and tear of
renting
to an outsider, the time value of money, one's cash needs, the
intangible headaches of being a landlord, the legal liabilities of a
landlord, the net cash flows from the rental activity, etc. The
purpose of this article was not to advocate
either renting or selling one's house, but to explore the possible tax
consequences of renting one's house for a couple of years and then
selling it. It is simplistic and is predicated on even more
simplistic assumptions. Please consult your attorney, tax
accountant, and other necessary professionals before undertaking any
such decision.
Have a tax or an accounting question? Please feel free to submit
it to William Brighenti,
Certified Public
Accountant, Hartford CPA Accountants. For information
and assistance on
any tax and accounting issue, please visit our website: Accountants CPA
Hartford.
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