My sister purchased some property in Florida at the peak in 2005.
It's now worth about two thirds of what she paid for it. If she sells
it at a loss, she can't deduct the loss because it was for personal
But suppose she rents for a while. When she depreciates the property,
can she depreciate it from her cost basis or from its current value?
How long must she rent it before it becomes "income" property that is
deductible when sold at a loss? Assuming she's owned it for four
years, but sells it two years from now, how much of the "loss" can be
deducted (or used to offset capital gains)?
In article ,
She determines her depreciable cost basis as the lower of FMV on
date it was placed into service as a rental, or adjusted cost basis.
Be sure she allocates between land which is not depreciable and the
building, which is depreciable, Straight Line, HY, 27.5 years.
I very much recommend anyone placing rental property into service
or disposing of rental property seek professional tax assistance.
While there is no specified term of rental use that changes
personal use property into rental property, many tax professionals
seem to accept 24 months of rental use as a practical dividing line.
The gain/loss on sale of house will be based upon the depreciable
basis, which is the lower of cost or FMV. So if she purchased for 1M,
and it was worth 600k when she started renting it, and she sells it
for 750k 3 years later, she has a gain of 150k plus the recaptured
depreciation (about 600k/27.5!.81k per year, or 65.45k over 3
years), so we're looking at 25% of 215.45k or 53.86k in tax. That's
federal tax only on the sale of business property, though the rate
could be lower than 25% in some cases. There's state tax too.
Florida has no personal income state tax, but if your sister lives in
CA, CA will want 9.55% of this 215.45k.
How much rental profit could she make in 3 years? From what I'm
seeing in the Bay Area, if one has a mortgage outstanding on 65% of
the original purchase price and the house was purchased a few years
ago during the boom, then with expenses excluding depreciation --
mortgage interest, property tax, condo fees, professional management
fees -- the rental is a net loss because the rent does not cover the
expenses. On the other hand if one has no mortgage there will likely
be a gain, but after depreciation there could still be a loss.
Suppose the rent is $4000 a month. Suppose no mortgage, property tax
$600 per month, condo fees $400 per month, management fees 6% of $4000
or $250. Net profit before depreciation is $2750. Depreciation is
600k/27.5!.81k per year, or 1.8k per month, so net profit is $950
per month. Assuming 1/3 of that is used to pay federal tax, we have
to pay about $315 per month in federal taxes. Cash flow is $2750 per
month, minus the $315 in taxes, or $2435 net per month, which is a
little less than 90k over 3 years. About 60% of this 90k will be used
to pay the 25% of 215.45k tax noted above, which is tax on the sale of
Of course, rents will increase over the 3 year period that you're
renting it, but in our recession the increase will be slight or not at
all. And it's doubtful that the house would appreciate 25% in 3 years
(from 600k to 750k). So what I'm saying is that if you start renting
now and hold it for only 3 years, you'll likely lose even more through
the payment of taxes.
Is this correct? At first blush it seems so wrong. At second blush, it
seems it might be right.
In either event, if you found yourself in this situation, what could you do
to reduce your tax exposure on a property you have a loss on? Convert back
to your personal residence? Anything else?
I would have worded it differently, but yes, it's right. When
property has been converted from personal use to rental the starting
point for depreciation is the lesser of adjusted basis or FMV at the
time of conversion. That makes it also the starting point for
determining the gain/loss upon ultimate sale of the property.
When our story began it was her personal residence and she was trying
to figure out a way to make tax use of a loss. If we're still at that
point, there is no tax exposure. If she does convert it to a rental
there will always be a recapture of depreciation when the property is
sold, even if she converts it back to a personal residence. The way
around it is to die without ever selling the property, in which case
the heirs get it with a basis equal to FMV and all that other stuff
goes to her grave with her.
Sure. But the issue is what does "gain" mean in this context? If
she originally purchased it for $1 million, converted it to rental
when it's worth $600,000 and then sells it when it goes back up to
$750,000, she has to recapture depreciation, of course. But is there
an additional $150,000 taxable income?
I find that hard to believe.
Pub 551 addresses this exact issue. I seem to recall having cut and
pasted these paragraphs here before in some other long-forgotten thread,
it's a topic that comes up every so often, I guess.
It's one of those counter-intuitive situations where your basis depends
on whether you are figuring gain or loss. In some corners of the tax
law, it is possible to dispose of property and have neither a gain nor a
loss (and I don't mean just zero). I mean when you use the basis for
purposes of figuring a gain, it yields a loss; when you use the basis
for purposes of figuring a loss, it yields a gain.
From Pub 551:
"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 snipped]
"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. [example snipped]"
Also I don't remember if it was mentioned earlier, but if the rental has
unused passive loss carryovers, they don't get used when converting back
to personal use, but rather when the property is finally disposed of.
If all the gain can be excluded due to Sec. 121 (less likely now under
new rules regarding periods of qualifying use), then the unused passive
Am still confused. How do we know whether we are figuring basis for
gain or for loss (in order to know which rules to apply)? In the
example of purchasing a house for 1M, converting it to rental when FMV
is 600k, and selling it 3 years later for 750k, with depreciation of
65k over those 3 years, which rules apply?
You don't, necessarily. Especially if you can't easily do depreciation
and land/building allocation calculations in your head.
Do it both ways. Use the basis for gain and see what you get, then use
the basis for loss and see what you get. Then you'll know which rules
In this case, you don't get a loss using the loss basis, and you don't
get a gain using the gain basis, so you have neither a gain nor a loss
(if I did that correctly in my head...)
Still not sure from other comments in this thread regarding taxable
unrecaptured Sec. 1250 gain, though...