Primary Residence converted to Rental - Capital Loss

[Snehal Ambare]

Hi! We bought our primary residence in Orlando FL in 2006 for $260,000. This year we are buying a new home and looking at potential to convert our current home to rental property. Would we be eligible to get tax break due to loss? Based on Zillow our current estimated value is $181,000.

[Naseer Khan]

@Snehal Ambare If you’re thinking of converting your personal residence into a rental in order to take advantage of the Section 1231 loss rules, you may want to reconsider because the IRS has implemented certain limitations for conversions. When you convert your personal residence to a rental property, your new cost basis will be the lesser of the following values on the date of conversion:

• The fair market value of the property, or
• The property’s current tax basis.

Because of this rule, if your personal residence has lost value since you bought it, turning it into a rental home won’t allow you to deduct the loss that occurred before the conversion when you eventually sell it. Only a drop in value after the conversion would be deductible.

Example:

You convert your residence into a rental when the property's cost basis is $350,000, and its FMV is $250,000. Later, you sell the property for $210,000, after claiming $15,000 in depreciation deductions.

Since the FMV was lower than the property's cost basis at the time of conversion, the FMV will be used as the cost basis. For tax loss purposes, your tax basis is $235,000 ($250,000 FMV on conversion date minus $15,000 depreciation = $235,000).

That means you do have a deductible loss, but it’s limited to $25,000 ($210,000 sale price – $235,000 basis = ($25,000) loss).

For simplicity, this example excludes the potential impact of carryover losses and depreciation recapture. Depreciation recapture is essentially paying tax on a portion of the depreciation deductions. Depreciation recapture tax is assessed at a different rate (25 percent in 2015) and only applies to the lesser of the gain or depreciation allowed.