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Converting a principal residence to rental property.

Homeowners and their tax advisors are familiar with the tax advantages of home ownership. Among the advantages are mortgage interest and property tax expense income tax deductions, tax deferral on the realized capital gain from the sale of a principal residence and the purchase of another residence at a purchase price that exceeds the selling price of the previously owned residence, and the exclusion of up to $125,000 in capital gain for eligible taxpayers 55 years and older at the time of sale.

During the period 1986-1989, homeowners used many of these benefits to their advantage. While the Tax Reform Act of 1986 eliminated or limited many commonly used income tax deductions (for example, the personal interest expense), most deductions related to home ownership were retained. In addition, the real estate market enjoyed a prosperous period in most parts of the United States. Taxpayers utilized the rollover of gain provisions of Internal Revenue Code (IRC) Section 1034, selling their principal residences at a gain and purchasing more expensive residences.

However, during the period 1990 through 1992, the real estate market experienced a recession in most parts of the United States. In some parts of the country, sellers were forced to sell their homes at prices below their "asking prices." Many sellers who had purchased their homes a few years earlier sold their residences at a loss; others removed their houses from the real estate market.

One alternative to selling one's principal residence has been to convert the property from a principal residence to a rental (investment) property. Several questions come to mind when this strategy is used. Among them:

* How are the rollover of gain provisions(1) affected by a conversion?

* Is the converted property eligible for depreciation? If so, what is the cost basis for depreciation? If the taxpayer purchases another principal residence, how does one compute the taxpayer's basis in the new residence?

* Are the mortgage interest and property tax expenses tax deductible for the rental property as they are (within limits) for the principal residence?

* Are casualty and theft losses subject to the $100 and 10% of adjusted gross income (AGI) limit restrictions(2) for rental property losses as they are for principal residence losses?

* What effect does the property conversion have on the $125,000 capital gain exclusion?

In this article, we shall investigate the answers to these and other relevant questions that frequently arise when a property is converted from a principal residence to a rental property. Relevant IRS revenue rulings and pronouncements, as well as court decisions, will be cited and reviewed in attempting to answer these questions.

It should be noted that one must determine initially the owner's purpose in renting his or her principal residence. For example, if the owner has a profit motive, then it must be determined if a "fair market" rent is being charged. If, on the other hand, the owner does not have a pure profit motive and only rents the property on a temporary basis (for example, prior to moving into a new principal residence) in order to have rent payments "match" the mortgage payments, then it can be assumed that the property has not been permanently converted. In this article, we shall assume that the owner has a profit motive and wishes to permanently convert his or her property.

Rollover of Gain Provisions

The provisions for the rollover of gain on the sale of a principal residence are contained in IRC Section 1034. If a taxpayer sells his or her principal residence at a capital gain, then tax on the gain will be deferred if another principal residence is purchased within two years before or after the sale of the old residence at a purchase price that exceeds the adjusted sales price of the old residence.

IRC Section 1034 imposes several requirements for the deferral of tax on the realized gain. Among them are the concurrent occupation of the old residence at the time of its sale. However, this does not imply that the taxpayer has to necessarily physically occupy the residence at the time of sale. In other words, it is generally agreed that the nonrecognition of gain provisions will apply when the taxpayer purchases and moves into a more expensive residence and temporarily rents the old residence prior to its impending sale.

During the period of temporary rental, the IRS has ruled (and the Tax Court has agreed) that expenses incurred in the renting of the old residence are deductible only to the extent of rental income under the "hobby loss" rules.(3) On the other hand, in a case in which the taxpayer had a profit motive in renting out his old residence, maintained expense records, and actively managed the property, a U.S. Court of Appeals court permitted the deduction of rental expenses in excess of rental income.(4) In another court case,(5) the IRS acquiesced to a Tax Court decision in which the court ruled that the abandonment of a residence and the listing of it for rent or for sale, whether successful or not, was an indication of an income (profit) motive. All expenses and losses, within the passive activity limits,(6) were therefore eligible to be deducted.

How will the permanent conversion to rental property affect the provisions of IRC Section 1034? In short, these provisions will no longer apply to the converted property. In their place, the "like-kind" provisions of IRC Section 1031 will apply to the property when it is sold. This implies that if the rental property is subsequently sold at a realized capital gain, then "like-kind" (in this case rental) property will have to be purchased at a higher price than the selling price of the older property (subject to other conditions(7)). On the other hand, a loss resulting from the sale of the property would be classified as a capital loss, assuming no other "like-kind" property is purchased.

Basis in Rental Property

When one converts a principal residence to rental property, the property's cost basis will be(8) the lower of its:

* Cost (including the original purchase price, settlement costs and capital improvements) and

* Fair market value (FMV) on the date of its conversion.

Once a basis is determined, any "start-up" costs for converting the property to a rental status (e.g., legal fees for creating a landlord/tenant lease and for establishing the property in accord with local rental regulations, if any) should be amortized over a period of no less than 60 months. Also, any personal property (e.g., furniture) that remains with the property for use will be eligible for depreciation. Its basis for depreciation will also be the lower of its cost and FMV on the date of conversion.

Basis in New Principal Residence

Under the provisions of IRC Section 1034, any realized gain from the sale of one's old residence will be deducted from the cost of a new principal residence (at a purchase price that exceeds the sales price of the old residence) in order to establish a basis for the new residence. However, in the situation described here, an "old" residence is not sold; instead, it is converted to rental property.

As a result of the conversion, any losses (e.g., casualty and theft losses) previously deducted from the basis of the converted residence and any prior unrecognized gains will be "carried over" to the new residence. The unrecognized gains and recognized casualty/theft losses will therefore be deducted from the purchase price (including the settlement costs) in establishing a basis for that residence. The following example illustrates the determination of basis in both the rental property and the new principal residence.

Example: Robert and Claire Abrams purchased a home in 1964 at a cost of $25,000. During the period 1964-1975, they made $10,000 of capital improvements. In 1976, they sold the house at an adjusted sales price of $65,000. They purchased another principal residence one month later at a purchase price of $75,000. Tax on the realized gain of $30,000 ($65,000 sales price less adjusted basis of $35,000) is deferred as a result of buying a more expensive principal residence.

In 1982, the Abrams experienced a fire in their house, causing $15,000 damage and a recognized loss of $5,000. In 1992, with their residence worth $100,000, the Abrams converted it to rental property and purchased another principal residence at a cost of $150,000. The bases in the rental property and newly acquired residence are computed in Table 1 below.

Mortgage Interest and Property Tax Deductions

Two commonly used income tax deductions are the mortgage interest and real estate property taxes. If a taxpayer itemizes, these expenses are reported on Schedule A of Form 1040 with the following limitations(9):

* For mortgages taken out after October 13, 1987, to buy, build or improve one's home (called "home acquisition debt"), the amount of mortgage interest plus any "grandfathered debt" (mortgages acquired prior to October 13, 1987) must not exceed $1,000,000.

* For mortgages taken out after October 13, 1987, other than to buy, build or improve one's home, the amount of mortgage interest must not exceed $100,000 ("home equity debt"). For taxpayers filing as married filing separately, the limits for (1) and (2) are $500,000 and $50,000, respectively.

* For those taxpayers with adjusted gross incomes (AGI) exceeding $100,000 ($50,000 if married filing separately), itemized deductions will be adjusted downward in the amount of 3% for every $1 over $100,000.(10) Mortgage interest and real estate property tax are two of the itemized deductions that are counted towards this limitation.

It is important to note that in the case of a principal residence, there are no "carryover" provisions for mortgage interest and property tax expenses that, because of these limitations, are not used in a given year. As we shall see, there are such "carryover" provisions with respect to annual expense limitations for rental property deductions.

With respect to rental property, mortgage interest and property tax deductions are allowed as rental expenses. There are no individual limits on these expenses; however, because rental activities are classified as "passive," there are passive activity limits of which an investor must be aware.

In particular, one cannot deduct passive losses unless there is passive income to offset these losses.(11) However, passive losses up to $25,000 ($12,500 if married filing separately) are allowed from rental activities in which an investor actively participates.(12) The passive losses may be used to offset earned income, portfolio income and passive income. The $25,000 ($12,500) limitation is reduced $1 for every $2 that a taxpayer's AGI exceeds $100,000 ($50,000); consequently, no passive losses are allowed when one's AGI exceeds $150,000 ($75,000). In spite of these limitations, any losses not used in a given year may be carried over to future years to offset capital gain when the property is disposed of.

How do the mortgage interest and property tax expenses affect the rental activity limits? As mentioned previously, the mortgage interest and property tax expenses are not individually limited; however, these expenses collectively, together with other rental expenses netted with rental income, are limited by the $25,000 loss limitations.(12) However, unused losses may be carried forward to be used to offset gains in future years.

In short, the "home acquisition debt" and "home equity debt" limitations for mortgage interest associated with principal residences do not apply to rental property. Furthermore, the owner of the property need not refinance the property in order to change the classification of the mortgage interest expense from "personal" to "investment."

Casualty and Theft Losses

As a result of a casualty or theft loss, an individual may be able to partially deduct the loss on his or her federal income tax return.(13) IRC Section 165 contains the provisions describing deductions for taxpayers who have incurred losses as a result of casualties, thefts and/or condemnations. The amount of a deductible loss depends partially on the type of property (personal versus business) sustaining a loss or theft. In this regard, a casualty loss or theft occurring in a principal residence is considered a personal loss while a casualty or theft occurring in a rental property is considered a business expense.

A loss resulting from a casualty or theft on non-business (personal) property will be deductible under the following circumstances:
Table 1
Rental Property
(1) Cost: $75,000
(2) FMV: $100,000(1)
Basis: $ 75,000(2)
Principal Residence
(1) Cost: $150,000
Less: Unrecognized Gains: (30,000)
Less: Recognized Casualty Losses: (5,000)
Basis: $115,000
1 On the conversion date
2 Lower of cost and FMV

* The taxpayer itemizes; and

* The loss, less any insurance reimbursement and $100, exceed 10% of one's AGI(13).

In most cases, the adjusted basis of the property destroyed or stolen will be used as the basis for the loss. Because of these requirements, it is usually unlikely that a casualty or theft occurring in a principal residence will be deductible.

The treatment of a casualty loss or theft incurred on a business or investment property differs from the treatment of individual (personal) casualty and theft losses in the following respects:

* No reduction of $100 and 10% of one's AGI.

* If the property is totally destroyed or stolen, the deductible loss is the property's adjusted basis less any insurance reimbursement.

* If the property is partially damaged, the deductible loss is the lesser of its fair market value (FMV) of the property and the adjusted basis of the property.

Therefore, in assessing a possible casualty loss for the rental property, one must first determine the extent of the damages to see if there is total or partial damage. This was not the case for property destroyed or stolen from a principal residence.

In short, a casualty or theft loss occurring in a rental property is somewhat more likely to be deductible than a casualty or theft occurring in a principal residence. For both types of properties, a property's basis will be adjusted downward in the case of deductible losses and upward for those losses or thefts not eligible to be deducted.

$125,000 Capital Gain Exclusion Provisions

IRC Section 121 allows taxpayers 55 years and over a one-time exclusion of $125,000 of realized gain on the sale of a personal residence. There are strict prerequisites for this exclusion.

They are:(14)

* A taxpayer and/or spouse must be 55 years or older at the time of sale.

* Neither spouse has previously used the $125,000 exclusion.

* The taxpayer and/or spouse must have lived in the sold residence for at least three out of five years (one out of the five years if the seller was in a nursing home at the time of the sale) preceding the sale.

The question here is, given that the taxpayer fulfills the other requirements of IRC Section 121, does renting out a property (previously used as a principal residence) disqualify it from the $125,000 capital gain exclusion? The answer to this question depends on whether the taxpayer has lived in the residence for three out of the five years preceding the sale. If he or she has, then the taxpayer will qualify for the exclusion. One must keep in mind, however, that the taxpayer's cost basis (used in the computation of the realized capital gain) will be affected by the amount of depreciation taken while the residence was rented.

However, tax planning for the future should be of utmost importance in this case. Because the $125,000 capital gain exclusion may be used only once, the taxpayer should consider whether to use the exclusion when he or she sells his or her current principal residence. In other words, will the future sale of the current principal residence result in a greater capital gain than the capital gain from the sale of the rental property?

Undoubtedly, this is a difficult question to answer. Nevertheless, if the taxpayer wishes to defer tax on the realized gain by purchasing "like-kind" property (in the case of the rental property) or another principal residence (in the case of the principal residence) in the future, then the question could be somewhat easier to answer.

In short, taxpayers should consider both the sale of the rental property and the future sale of a principal residence in anticipation of current and future tax liabilities. The $125,000 capital gain exclusion should be one of the factors affecting these decisions.

Summary and Conclusions

We have discussed the conversion of a principal residence to rental property. Several tax consequences may come about as a result of this conversion. We have reviewed some of the more important issues that a taxpayer will confront when a property is converted, including basis of the converted property for depreciation, deducting a capital loss if the property is sold at a loss, eligibility for deductible casualty and theft losses, and eligibility for the $125,000 capital gain exclusion for taxpayers 55 years and older at the time of sale.

The situation described in this paper has received more attention in recent years due to the slump in the real estate market. It is anticipated that in spite of the recent improvement in the real estate market, there will be homeowners who will decide for one reason or another to convert their principal residences to rental property. Tax practitioners should therefore be aware of current and future IRS rulings and court cases that will perhaps affect these and other issues not described in this paper.


1 IRC Section 1034

2 IRC Section 165(c)(3),h

3 IRC Section 183

4 S.B. Bolaris, U.S. Tax Court decision.

5 M.L. Robinson, U.S. Tax Court decision

6 IRC Section 469

7 IRC Section 1031

8 IRC Sections 167(a)-2, 167(g)-1

9 IRC Section 163

10 IRC Section 68

11 IRC Sections 469(a) and (b)

12 IRC Section 469(c)(2)

13 IRC Section 165

14 IRC Section 121

Edward A. Zurndorfer, EA, is enrolled to practice before the Internal Revenue Service. He is also accredited in accountancy and taxation by the Accreditation Council for Accountancy and Taxation |SM~. A member of NSPA, he has published several articles on individual and small business taxation in professional tax journals.
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Author:Zurndorfer, Edward A.
Publication:The National Public Accountant
Date:Jun 1, 1993
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