Accountants CPA Hartford
William Brighenti, Certified Public Accountant
Certified QuickBooks ProAdvisor
Office Address:  46 Mildrum Road, Berlin, Connecticut 06037-2423      Phone:  (860) 828-3269      Email:  info@cpa-connecticut.com
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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:
  1. They owned the condo for at least two of the five years before the sale;
  2. Both used the condo as their principal residence for at least two of the five years before the sale; and
  3. 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.
If and only to the extent that this publication contains contributions from tax professionals who are subject to the rules of professional conduct set forth in Circular 230, as promulgated by the United States Department of the Treasury, the publisher, on behalf of those contributors, hereby states that any U.S. federal tax advice that is contained in such contributions was not intended or written to be used by any taxpayer for the purpose of avoiding penalties that may be imposed on the taxpayer by the Internal Revenue Service, and it cannot be used by any taxpayer for such purpose.  The above tax advice was written to support the promotion or marketing of the accounting practice of the publisher and any transaction described herein.  The taxpayer recipients of this offering memorandum should seek tax advice based on their particular circumstances from an independent tax advisor .
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