With the crash of the real estate market some are looking to capitalize and purchase larger homes for a bargain price. In doing so, they face the problem of selling their current residence to make the move up. With the lack of buyer interest and with some people not willing to take such a large loss people are holding out for the market to rebound. This creates the problem of carrying two mortgages, which the monthly payments on two mortgages can create cash flow problems for many taxpayers in this situation.
To help with this burden, a taxpayer may decide to rent out their prior residence to help bring in cash and cover the monthly costs on that property. If the tax payer decides to go this route there are a number of rules/guidelines that one has to be aware of.
Rental vs. Vacation Property
The first of these rules (which would only apply to the first year of renting) is determining if the property being rented qualifies as a “rental property” or a “vacation property.” The general rule is if the home was personally used for more than the greater of 14 days or 10% of the days the dwelling is rented for the year it is classified as a vacation home and subject to the rules under code section 280A. The main difference between a rental and vacation property is the expenses that can be deducted. If it is classified as a vacation property the only rental expenses that are deductible is the portion of the year that the property was rented. If it is deemed to be a rental property all expenses are considered business related and possibly deductible. For the sake of this conversation we are assuming that this rule is met and the home qualifies as a rental property.
Depreciable Basis of a Property
After determining the home is a rental property the first step is determining the depreciable basis of the property. When a personal home is converted to business use, the total basis is calculated by taking the lower of the adjusted basis or the fair market value of the property on the date of conversion. If the property was a personal residence and no depreciation was taken for business use of home you should go back to the purchase documents of the home to determine original cost which would also be the adjusted basis. Once the total basis is calculated the land portion is broken out and the remaining portion is considered the depreciable basis. Once the depreciable basis is calculated it must be depreciated using the method and recovery period set by the IRS at the time of conversion (at this time the method to be used is straight line and recovery period is 27.5 years for residential property).
Along with depreciation expense the taxpayer must start keeping records of the income earned and expenses incurred in renting the home. The list of expenses that are deductible for rental properties is longer than that for a personal residence. Many of the costs of renting a home (mortgage interest, real estate taxes, insurance, advertising, repairs and maintenance, supplies, etc.) are deductible.
First Time Home Buyer Credit
If the home was purchased within 2008 or 2009 and the first time home buyer credit was taken on the purchase there may be additional tax consequences to consider. If the home for which the first time home buyer credit is taken is converted to a rental property within 36 months of purchase a portion of the credit will be required to be repaid. This portion will depend on how long the home was used as a personal residence.
Selling the Property
Finally, after a taxpayer converts their former personal residence to rental property and gets to the point that they want to sell it there are more rules to be aware of. First the gain or loss must be calculated, and to do this the basis of the property must again be calculated. The basis can differ depending on if the property is being sold at a gain or a loss. If the property is sold at a gain, the basis of the property is the original cost basis to the taxpayer, plus any amounts paid for capital improvements (capitalized and not previously deducted), less any depreciation taken. If the property is sold at a loss, the basis is the lower of the original cost basis or the fair market value at the date of conversion, plus any capital improvements, less any depreciation taken. Rental property, when sold, is treated as a capital gain/loss but just because it was rented for a short period of time does not completely preclude the taxpayer from taking advantage of the gain exclusion rules for a personal residence. If the property is rented for less than 3 years before being sold, the taxpayer may still be eligible to take a portion of the personal home gain exclusion. This gain exclusion cannot be used against gain from recapture of depreciation though.
With the current state of the real estate market, renting a prior personal residence may be beneficial for a taxpayer to help wait out the recession and see some of the buyer interest and value come back. If one decides to go this route these are the rules/guidelines that should be considered at each stage of the process.
Contact our CPAs, business and financial advisors in Cleveland or Akron at 440-449-6800 or www.skodaminotti.com.