Personal residence converted to rental.

The lower of the two. I looked this one up not long ago for a friend. I think it's in Pub 551.

-------------- Phil Marti, VITA Volunteer Clarksburg, MD

Pub 551 -

I read this differently that either of the OP's choices.

There are two steps - first, one depreciates based on the values when put into service as a rental. Second, upon sale the basis is the original (purchase) basis minus the depreciation taken. This results in neither (of those choices) being the correct basis used for the final sale.

Joe

Yes, it is in Pub 551, the last topic under "Basis Other Than Cost".

It's not necessarily the lower of the two, but rather you use a different basis for calculating a gain than you do for a loss. An example of a residence converted to rental is provided in the Pub.

In the same pub, discussing property received as a gift, it is explained how it is possible to have neither a gain nor a loss upon disposition. I suppose the same thing could happen with the property converted to rental use.

Example, assuming a period when real estate values drop and then partially recover:

Purchase price of residence: $200K FMV when converted to rental: $120K Depreciation allowed: $10K Sale price of rental: $150K

gain = $150K - ($200K - 10K) => loss

loss = $150K - ($120K - 10K) => gain

I would need to do a quick check on whether or how unrecaptured Sec.

1250 gain would be taxed in this example, I don't think it's an issue if there is in fact no gain (which does not, as show above, necessarily imply there was a loss).

-Mark Bole

Thank you Mark, and well done. This is a very often overlooked "subtlety" in the "what's my gain" discussion, which we'll be having more of nowadays, what with the economy and all.

Using your figures...

Purchase price of residence: $200K FMV when converted to rental: $120K Depreciation allowed: $10K Sale price of rental: $150K

gain = $150K - ($200K - 10K) => loss - none to be taxed loss = $150K - ($120K - 10K) => gain - none to deduct

There's neither a taxable gain nor a deductible loss when the house sells for $150K. And with no gain, there's also no unrecaptured section 1250 gain to deal with, by definition.

Using your figures, still, but changing the sale price to $215K, the taxable gain would be $25K [selling price less original cost adjusted for depreciation taken] of which $10K would be potential unrecaptured section 1250 gain. I say "potential" unrecaptured section 1250 gain because if there are losses from other things, the section 1250 gain may be reduced when the gains and losses are netted together.

Is the $25K gain section 1231 gain, because it's rental property being sold, and/or is that gain excludible from income (except for the $10K of it that is the gain caused by the depreciation taken) if the principal residence section 121 rules apply, basically the rental period was three years or less?

That would be be basis for purposes of depreciation. Basis for gain/loss on sale goes back to the original acquisition.

But that goes back to the comment in the original post -- are you saying that the unrealized loss during the period of personal use is now fully deductible simply because it was converted to a rental?

According to Pub 551, you use a different basis to calculate gain than to calculate loss, see also § 1.165-9.

-Mark Bole

No. However, it's still the starting point. There's still some implied consumption (which would be [non-accelerated] depreciation had the asset been placed in service from day one) that adjusts the basis, but blindly using the [lower] FMV at the time of conversion also isn't correct.

Without reviewing the TR, my instinct says that is wrong. However, I agree that not all of the loss would be deductible due to the personal use period. However, as I practice in California, where except for the past 2 years assets always appreciated in value, this generally isn't seen.

Instead of the admittedly blind trying to lead the allegedly blind, let's view the exact quote from Pub 551, which is echoed in the TR:

"Sale of property. If you later sell or dispose of property changed to business or rental use, the basis of the property you use will depend on whether you are figuring gain or loss.

"Gain. The basis for figuring a gain is your adjusted basis when you sell the property. [example omitted]

"Loss. Figure the basis for a loss starting with the smaller of your adjusted basis or the FMV of the property at the time of the change to business or rental use. Then adjust this amount for the period after the change in the property's use, as discussed earlier under Adjusted Basis, to arrive at a basis for loss. "

-Mark Bole