REI fudged the tax basis calculations

[George P.]

ran into a REI investor yesterday and we got to talking about his rental properties (that he apparently sold).

he suggested that the last one he sold, was originally converted from a primary residence.

his calculation of the tax basis use the FMV of the property at the time of conversion. I don't quite remember the numbers, but the property price more than doubled by the time he converted it. By the time he sold it, it went up in price some more.

His reasoning is that he should not pay the capital gain on the amount the property appreciated before he converted it, because the proceeds would otherwise be tax-free (due to primary residence $500k exclusion). He only pays capital gain on the amount the property appreciated after he converted it (plus depreciation recapture).

I see his point and understand that in Canada they use FMV at the time of conversion.

--> Thoughts from the REI veterans on this strategy, potential issues with IRS etc. ?

[Brandon Hall]

@George P. the answer is “maybe” but the way he is approaching it is 100% incorrect.

You can reduce your capital gain by $250k ($500k if MFJ) via the Section 121 exclusion. To qualify, you need to live in the property for two of the last five years.

So this guy could have bought the property in 2012, moved out two years later in 2014, rented it for a couple of years and then sold it by 2017. This would allow the facts to say “of the last five years, taxpayer lived in the property as his primary residence” which would qualify him for the Sec 121 exclusion. As a result he can exclude $250k ($500k if MFJ) of capital gain.

But what you absolutely cannot do is increase your cost basis when you convert to a rental property. The basis on a rental converted from a personal residence is the lesser of FMV or adjusted basis at the time of conversion. Because of this, if the property has appreciated since purchase, you don't get to increase the cost basis to wipe out the gain.

What are the risks? Well the IRS could audit the guy and realize what he’s done. Then they can assess all sorts of fun penalties that will cost a lot in professional services to fix.

Best piece of advice: don’t take tax advise from a non-tax professional.