29.9 Loss on Residence Converted to Rental Property
You are not allowed to deduct a loss on the sale of your personal residence. If you convert the house from personal use to rental use you may claim a loss on a sale if the value has declined below the basis fixed for the residence as rental property.
Filing Tip
To determine if you have a loss for tax purposes, you need to know the conversion date basis. This is the lower of (1) your adjusted basis (29.6) for the house at the time of conversion or (2) the fair market value at the time of conversion. Add to the lower amount the cost of capital improvements made after the conversion, and subtract depreciation and casualty loss deductions claimed after the conversion. To deduct a loss, you have to be able to show that this basis exceeds the sales price. For example, if you paid $200,000 for your home and convert it to rental property when the value has declined to $150,000, your conversion date basis for the rental property is $150,000. If the property continues to decline in value, and you sell for $125,000 after having deducted $10,000 for depreciation, you may claim a loss of $15,000 ($140,000 − $125,000). Your loss deduction will not reflect the $50,000 loss occurring before the conversion.
Caution
Partially rented home.
If you rented part of your home for over three years during the five years preceding the sale, you must allocate the basis and amount realized between the portion used as your home and the rented portion (29.7). A loss on a sale is allowable on the rented portion, which is reported on Form 4797.
Profit-making purposes.
Renting a residence is a changeover from personal to profit-making purposes. If the house is merely put up for rent or is rented for several months prior to a sale, the IRS may not recognize the house as rental property and may disallow the loss deduction. However, the Tax Court has approved a loss deduction where a house was rented on a 90-day lease with an option to buy. The court set down the following two tests for determining when a house is converted to rental property: (1) the rental charge returns a profit and (2) the lease prevents you from using or reoccupying the house during the lease period. Under the Tax Court approach, you have a conversion to rental property if you have a lease that gives possession of the house to the tenant during the lease period and if the rent, after deducting taxes, interest, insurance, repairs, depreciation, and other charges, returns you a profit.
Loss allowed on house bought for resale.
A loss deduction may also be allowed where you acquired the house as an investment with the intention of selling it at a profit, even though you occupied it incidentally as a residence prior to sale. In an unusual case, an owner bought a house with the intention of selling it. He lived in it for six years, but during that period it was for sale. The Tax Court allowed him to deduct the loss on its sale by proving he lived in it to protect it from vandalism and to keep it in good condition so that it would attract possible buyers.
In another case, an architect and builder built a house and offered it for sale through an agent and advertisements. He had a home and no intention to occupy the new house. On a realtor’s advice, he moved into the house to make it more saleable. Ten months later, he sold the house at a loss of $4,065 and promptly moved out. The loss was allowed on proof that his main purpose in building and occupying the house was to realize a profit by a sale; the residential use was incidental.
Gain on rented residence.
You have a gain on the sale of rental property if you sell for more than your adjusted basis at the time of conversion, plus subsequent capital improvements, and minus depreciation and casualty loss deductions. The sale is subject to the rules in Chapter 44 for depreciable property.