Temporarily converting a personal residence to income-producing property.
Converting a Personal Residence
to Income-Producing (Rental) Property
Sec. 280A(a) refers to a personal residence as a "dwelling unit," which in turn is defined in Sec. 280A(f) as "a house, apartment, condominium, mobile home, boat, or similar property...." The regulations under Sec. 1034 further state that the personal residence of a taxpayer "depends upon all the facts and circumstances in each case, including the good faith of the taxpayer."(1) Therefore, if a taxpayer is actually living in a house with the intent that the house be his primary residence, it generally is the taxpayer's personal residence for Federal tax purposes.
The term "dwelling unit" is also included in the definition of "residential rental property" in Sec. 168(e)(2)(A): "[A]ny building or structure if 80 percent or more of the gross rental income ... is rental income from dwelling units." A "dwelling unit" is further defined in that same Code section as "a house or apartment used to provide living accommodations in a building or structure...."(2) Therefore, if a taxpayer transfers his personal residence to another location, intends to turn the previous dwelling unit into income-producing property, and rents the previous residence at a fair market value (FMV), the previous residence has been transformed from a personal residence to income-producing property.
The Federal Income Tax Implications
of a Conversion
Depreciation (or "cost recovery" as it was termed in the Economic Recovery Tax Act of 1981 (ERTA)) is one of the first items to be considered when considering rental expenses. Depreciation is "a reasonable allowance for the exhaustion, wear and tear (including a reasonable allowance for obsolescene) ... of property held for the production of income."(3) The amount of depreciation under Sec. 167(a) is determined by using a specific method, a specific life ("applicable recovery period") and a specific convention.(4) The only method of depreciation available under the Tax Reform Act of 1986 (TRA) for residential rental property purchased and placed into use after Dec. 31, 1986 is the straight-line-method;(5) the only life available is 27.5 years;(6) and the only convention available is the mid-month convention, which assumes that all property is placed in service at the midpoint of the month, thereby allowing one-half of a month's depreciation in the first month.(7)
The depreciation expense for any given year is determined by taking these three items and applying them to the property basis. Basis for depreciation is the adjusted basis determined under Sec. 1011.(8) Sec. 1011 refers to Sec. 1012, under which the basis of property begins with cost. Therefore, the original cost of a given property is the place to start in the determination of basis.
* Adjustment to basis
Adjustments to basis are determined by Sec. 1016. Expenditures that increase the value of life of a dwelling unit are capital expenditures ("chargeable to capital account") and increase the basis; e.g., a room or garage addition, landscaping, a new roof, or other permanent improvements that make the unit more valuable or useful. Any expenditures that are considered in the determination of taxable income for any tax year are not considered to be chargeable to capital account.(9) Therefore, these expenditures would not increase basis.
Losses, such as casualty losses, that are chargeable to capital account reduce basis.(10) Another item that decreases basis is the greater of depreciation allowed (actually deducted on a tax return) or depreciation allowable (what should have been deducted on a tax return.)(11) If no depreciation deduction has been claimed, the allowable amount is determined using the straight-line method.(12) Other decreases in basis include such items as gains on the sale of prior residences when the realized gain was not recognized (taxable) due to a Sec. 1034 reinvestment in another personal residence within the four-year time period(13) (discussed later).
One other interesting basis adjustment is the real estate tax assumed by a buyer on the purchase of real property. If property which taxes are due is purchased, these taxes must be prorated based on whether they are the liability of the seller or the buyer.(14) Any taxes paid by the buyer that are not his liability are not currently deductible;(15) instead, they increase the basis of the property purchased.
If a personal residence has decreased in value since the original purchase or basis adjustments, the FMV could be lower than the adjusted basis. For property transformed personal use property (i.e., a personal residence) to income-producing property (i.e., a rental unit), "the fair market value on the date of such conversion, if less than the adjusted basis of the property at that time, is the basis for computing depreciation."(16) Therefore, if a personal residence is converted to a rental unit when its FMV is below its adjusted basis, the FMV becomes the adjusted basis. All depreciation is calculated using the lower adjusted basis amount.
* Yearly expenses
Yearly expenses that are deductible in calculating taxable income or loss include "ordinary and necessary expenses paid or incurred during the taxable year - (1) for the production or collection of income; [or] (2) for the management, conservation, or maintenance of property held for the production of income...."(17) Furthermore, these expenses are deductible before the determination of adjusted gross income (AGI).(18) These ordinary and necessary expenses of the rental unit are deductible even though the property was once the taxpayer's personal residence.(19) Although under Sec. 280(a) an individual is no allowed deductions for items relating to the personal use of a dwelling unit, Sec. 280(c)(3) states the "Subsection (a) shall not apply to any item which is attributable to the rental of the dwelling unit...." Deductible expenses include taxes, interest. repairs and maintenance, insurance, agents' commission, advertising, cleaning, legal and other professional fees, supplies, utilities, wages and salaries and travel. If a personal automobile is used, a deduction is allowed for the greater of actual automobile costs related to the rental property or 28 cents per mile in 1993.(20)
* Hobby loss rules
The hobby loss rules of Sec. 183 do not apply to a complete conversion of a personal residence to rental property since the entire property is income-producing property under Sec. 212 and not "activities not engaged in for profit" under Sec. 183.
* Passive activity rules
Any individual(21) renting a dwelling unit comes under the passive activity rules; the term "passive activity" includes any rental activity unless the taxpayer is in a real estate business.(22) A rental activity is " any activity where payments are principally for the use of tangible property."(23) Under the passive activity rules, losses are generally not allowed.(24) However, any passive losses may be offset against passive income. Therefore, the term "passive loss" refers only to the excess of aggregate passive losses over aggregate passive income for a given year.(25) Any disallowed losses may be carried forward and deducted against future passive income(26) or, at the point of sale of the passive activity, may be deducted against other types of income.(27)
Another benefit allowed to rental real states activities is the $25,000 annual deduction allowed under Sec. 469(i). If an individual taxpayer has AGI of $100,000 or less and actively participates in the rental activity, a deduction is allowed for the lesser of the actual loss calculated on Schedule E or $25,000. As AGI increases above $100,000, the $25,000 amount is reduced by 50 of the excess AGI.(28) Active participation, as it relates to rental units, requires ownership of 10% or more (29) and involvement in management decisions, such as approving capital expenditures and arranging for repairs " in significant and bona fide sense."(30) (Emphasis added.) The involvement of a spouse is included as part of a taxpayer's participation.
Federal Income Tax Implications
When Property Is Sold Without Being
Converted Back to a Personal Residence
When residential rental property is sold, Sec. 1250 applies. Sec. 1250 property includes "any real property... which is or has been property of a character subject to the allowance for depreciation provided in section 167."(31) However, Sec. 1250 applies only to excess depreciation over depreciation that would have resulted if the straight-line method had been used for all depreciation allowed or allowable.(32) Therefore, since depreciation under the modified accelerated cost recovery system (MACRS) for residential rental property placed into service after Dec. 31, 1986 is limited placed straight-line depreciation, the ordinary income provisions of Sec. 1250 do not apply. All gains and losses go back under Sec. 1231. After being netted with all other Sec. 1231 gains and losses for the current year, a net gain or loss results. If the result is a gain, and there have been no Sec. 1231 losses in the last five years, it is a long-term capital gain. If the result is a loss, it is an ordinary loss.(33) If there have been any Sec. 1231 net losses in the last five years, net gains become ordinary income to the extent of noncaptured net Sec. 1231 losses in that five-year period.(34)
There is no provision in the Code or regulations for postponement of a realized gain on the sale of income-producing property as there is under Sec. 1034 for a personal residence (see below). There is also no exclusion of gain allowed for income-producing property as there is under Sec. 121 for a personal residence (see below) However, there are nonrecognition provisions that apply to rental property disposed of in like-kind exchanges under Sec. 1031 and involuntary conversions under Sec. 1033. Under Sec. 1031, if strict rules are followed, a taxpayer can trade income-producing property for other income-producing property and not recognize a gain. Assuming no cash or other boot is involved, the basis of the property received. Under Sec. 1033, if a taxpayer is forced to give up rental property due to an involuntary conversion, there is a reinvestment period during which the proceeds from the involuntary conversion can be reinvested in other similar property to avoid any recognition of gain.
Federal Income Tax Implications
When Property Is Converted Back
to a Personal Residence and Later Sold
If taxpayer, "in good faith," moves back into a dwelling unit, it can be argued that the house is again the personal residence of the taxpayer:" The mere fact that property is, or has been, rented is not determinative that such property is not used by the taxpayer as his principal residence."(35) However, the adjusted basis of a rental unit at the end of the rental period, including any decreases in basis for items like depreciation, becomes the adjusted basis of the personal residence.
On a subsequent sale of the personal residence, as long as certain holding period requirements are met, a taxpayer may qualify for postponement or exclusion of a part or all of a gain. If a taxpayer reinvests the net proceeds of the sale of the old residence into a new residence within a period that begins tow years before the sale of the old residence and ends tow years after the sale of the old residence, and moves into the new residence within the dame time period, any gain is postponed. If the total net proceeds are not reinvested into another personal residence any excess net sale proceeds over the cost of the new residence become taxable to the extent of any gain realized.(36) Realized gain is the difference between the net sale price (gross sale price less expenses of the sale) and the adjusted basis of the property sold.
As a general rule, this postponement can occur only once every two years."(41) Therefore, if more than one dwelling unit is purchased and used as a personal residence within the two-year period after the sale of the first personal residence, only the last personal residence purchased within such period will qualify for the postponement of gain.(37) There are exceptions to the general rule: The minimum two-year rule does not apply when a taxpayer sells his personal residence due to a change of job (so long as the move qualifies for the moving expense deduction under Sec. 217).(38) The two-year period is increased for members of the armed forces(39) and individuals whose tax home is out-side the United State(40) to four and/or eight years, depending on the specific situation.
If a taxpayer or spouse is 55 or older on the date of sale of the old residence, an exclusion of up to $125,000 is available. A taxpayer qualifies for this one-time exclusion if "during the 5-year period ending on the date of the sale or exchange, such property has been owned and used by the taxpayer as his principal residence for periods aggregating 3 years or more."(41) Therefore, if a property has been temporarily rented for a period of time, it will be necessary for a taxpayer to reestablish his personal residence in the property and be sure that the three-year is met. The amount of the exclusion is the lesser of the realized gain or the $125,000 maximum exclusion. This is a once-in-a-lifetime exclusion for both the taxpayer and spouse. For taxpayers 55 or older who reinvest the sale proceeds in a new personal residence, this exclusion election can be considered first before the postponement of Sec. 1034.(42) Therefore, tax-payers having attained the age of 55 can sell their personal residence exclude the gain under Sec. 121 and reinvest in a smaller personal residence without adverse tax consequences.
If a personal residence is sold and the proceeds are not reinvested, and the taxpayer or spouse is not 55 or older, the sale comes under the capital asset sale rules. If a gain results from the sale, it is a capital gain. However, since a home is a personal asset, any loss in a nondeductible personal loss.(43)
When a homeowner decides to be a away form his personal residence for an extended period of time, the property can be turned into income-producing property. By planning carefully before the conversion, the homeowner can derive tax benefits through the deduction of ordinary and necessary expenses, including depreciation, against the fair market rental income received.
If net income results, it is combined with other passive income/loss items and any resulting net gain is taxable. If a net loss results, it is also combined with other passive income/loss items and any resulting net loss may be deductible up to a maximum of $25,000. If the property is sold before being converted back to a personal residence, any gain is taxable and any loss is deductible. However, the property can be converted back to a personal residence and if proper time periods are observed, any gain can be either postponed or excluded. On the other hand, if a loss results, it is a nondeductible personal loss. Therefore, if a loss is expected, it is better to sell the property as income-producing property. If a gain is expected, it is better to sell the property as a personal residence.
(1) Regs. Sec. 1.1034(c)(3)(i). (2) Sec. 168(e)(2)(A)(ii)(I). (3) Sec. 167(a). (4) Sec. 168(a). (5) Sec. 168(b)(3)(B). (6) Sec. 168(c)(1). (7) Sec. 168(d)(2) and (4)(B). (8) Sec. 167(c). (9) Regs. Sec. 1.101-2(a). (10) Sec. 1016(a)(1). (11) Regs. Sec. 1.1016-3(a)(1)(i). (12) Regs. Sec 1.1016-3(2)(i). (13) Sec. 101(a)(7). (14) Sec. 164(d). (15) Sec. 275(a)(5). (16) Regs. Sec. 1.167(g)-1. (17) Sec. 212. (18) Sec. 62(a)(4). (19) Regs. Sec. 1.212-1(h). (20) Form 1040, Schedule E and Instructions for Schedule E. (21) Sec. 469(a)(2)(A). (22) Sec. 469(c)(2). (23) Sec. 469(j)(8). (24) Sec. 469(a)(1). (25) Sec. 496(d)(1). (26) Sec. 469(b). (27) Sec. 469(g)(1)(A). (28) Sec. 469(i)(3)(A). (29) Sec. 469(i)(6)(A). (30) S. Rep. No. 99-313,99th Cong, 2d Sess. 737-738 (1986). (31) Sec. 1250(c). (32) Sec. 1250(b)(1). (33) Sec. 1231(a)(1) and (2). (34) Sec. 1231(c). (35) Regs. Sec 1.1034-1(c)(3)(i). See also Rev. Rul. 82-26, 1982-1 CB 114. (36) Sec. 1034(a). (37) Sec. 1034(c)(4). (38) Sec. 1034(d)(2). (39) Sec. 1034(h). (40) Sec. 1034(k). (41) Sec. 121(a)(2). (42) Sec. 121(d)(7). (43) Sec. 165(c).
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|Author:||Miller, Sandra K.|
|Publication:||The Tax Adviser|
|Date:||Feb 1, 1994|
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