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Tax implications of selling a rental home that used to be a personal home

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#1
What is the name of your state? MI

Hi,

In 2003 I purchased a home for 143K, lived in it for 8+ years, then I converted it to a Rental in April 2012. The only reason converted to rental was because the home depreciated to the point that it was worth less than the mortgage balance. Anyway, at the time that the home was put in service the FMV of the house was about 78K which I took as my cost basis for tax purposes/depreciation.

Fast forward to now, the house has gone up in value to about 120K and the mortgage balance has gone down to about 90K. I really don't want to be a landlord and the tenants want to purchase the house so it makes some sense for me to sell the home now, pay the mortgage off and be happy not worrying about it anymore :). However, I started researching how a gain or loss would be calculated in my particular situation and want to make sure that I am understanding everything correctly before I agree to sell the home.

It seems to me, based on what I have read doing google searches and IRS Pub 544 is that if there is a gain I can use the original purchase price as my cost basis but if there is a loss then I have to use whatever I used as my cost basis when the rental was put in service. This is a little confusing for me and I have not been able to find a similar example out there that explains the calculation. What I think would happen would be (assuming a 120K selling price as an example and 10K depreciation since it was put in service): 120K - 78K - 10K = 32K gain which would then be subject to capital gains (I think) plus any recapture tax. Is that correct?

Assuming my understanding above is correct, if I were to not sell the home and then wait until I could sell it for something over the original selling price of 143K, would the calculation be different? Assuming 145K selling price: 145K - 143K - depreciation? Is that how that would work? If so, it seems that it would be better to wait until the house appreciates above the original purchase price than to sell it now (at least in terms of the taxes to be paid on a gain).

Thanks for reading and any advise/education you can provide, I truly appreciate it.
 


HRZ

Senior Member
#3
unless the rental is generating a tidy profit it may well make sense to get out of business and risks of being a LL ...irrespective of any small tax points .

Are your tenants willing to buy at a price you think is consistent with market value AND are they likely able to get financing ?
 

Taxing Matters

Overtaxed Member
#4
What I think would happen would be (assuming a 120K selling price as an example and 10K depreciation since it was put in service): 120K - 78K - 10K = 32K gain which would then be subject to capital gains (I think) plus any recapture tax. Is that correct?
No, that's not correct. You would simply have no loss to deduct. With 10k of depreciation taken (or that could have been taken) you end up with an adjusted basis in the property of $143k cost - 10k depreciation equals $133k adjusted basis, assuming no other adjustments to basis. Thus, if you sell the property for $120k you will have a loss of $13k. Because the property had been converted to rental use and you are selling at a loss, you must instead use the FMV at the time of conversion to determine your cost basis for the loss. Here, that is $78k. So, $78k cost less $10k depreciation = $68k of basis. You are selling it at $120k. Since the amount realized from the sale ($120k) exceeds the basis for determing your loss, your loss is zero. Read the rules on page 10 of Publication 544 under the heading Property Changed to Business or Rental Use and take close note of step 4 and you will see that this is the result you get. So in that case, you have no gain on which to pay tax, but you have no deductible loss you can use to offset other income either. The reason for this rule is that a loss on personal property is not deductible. So using the FMV at conversion to determine the basis for loss ensures that the only loss you deduct is on the business use, not personal use of the property.

So no, it would not benefit you in terms of tax to wait for appreciation above your adjusted basis.
 
#5
No, that's not correct. You would simply have no loss to deduct. With 10k of depreciation taken (or that could have been taken) you end up with an adjusted basis in the property of $143k cost - 10k depreciation equals $133k adjusted basis, assuming no other adjustments to basis. Thus, if you sell the property for $120k you will have a loss of $13k. Because the property had been converted to rental use and you are selling at a loss, you must instead use the FMV at the time of conversion to determine your cost basis for the loss. Here, that is $78k. So, $78k cost less $10k depreciation = $68k of basis. You are selling it at $120k. Since the amount realized from the sale ($120k) exceeds the basis for determing your loss, your loss is zero. Read the rules on page 10 of Publication 544 under the heading Property Changed to Business or Rental Use and take close note of step 4 and you will see that this is the result you get. So in that case, you have no gain on which to pay tax, but you have no deductible loss you can use to offset other income either. The reason for this rule is that a loss on personal property is not deductible. So using the FMV at conversion to determine the basis for loss ensures that the only loss you deduct is on the business use, not personal use of the property.

So no, it would not benefit you in terms of tax to wait for appreciation above your adjusted basis.
Thanks so much!! That was the confusing part to me. I think I understand now, I was hung up thinking that there were 2 ways to calculate gain or loss but I now understand that the calculation is the same (using the original purchase price and depreciation) and once you determine if it is a loss then that is when the basis at time of conversion to rental is used. I appreciate your help very much.
 
#6
unless the rental is generating a tidy profit it may well make sense to get out of business and risks of being a LL ...irrespective of any small tax points .

Are your tenants willing to buy at a price you think is consistent with market value AND are they likely able to get financing ?
Thanks for your reply. The tenants are willing to buy at the current market value but will want to negotiate the final price (which I understand from their point and have no problem with). The interesting part is them being able to secure financing, they are indicating that they are able to and I'm taking them at their word, but 2 years ago they were unable, some things have changed on their end so we'll see.
 

HRZ

Senior Member
#7
just be sure about ability to finance and or a major down payment and if unable,to,get conventional,financing do NOT step,into,breech wo a long talk with your lawyer and 2 cases of your strongest,beverage...
 

Taxing Matters

Overtaxed Member
#9
The appellate court in the 9th came down with a decision on this issue a few months ago--overturning the tax court. If anyone reading needs to see the reasoning IN DEPTH, go to:
https://www.leagle.com/decision/intco20180314h68
The decision you linked is not to a ninth circuit court opinion. It is to a recent Tax Court opinion that is about a cancellation of debt issue and has nothing to do with the OP's situation.
 

Whoops2u

Well-known member
#10
The decision you linked is not to a ninth circuit court opinion. It is to a recent Tax Court opinion that is about a cancellation of debt issue and has nothing to do with the OP's situation.
My mistake, it was just the tax court. But, to say it has nothing to do with the OP's situation seems in error. Go to Part III, The gain or Loss Computation and read through that to C. The Calculation:

Here we have a slight problem. The Simonsens realized $555,960, which falls between the basis we would use to calculate a loss ($495,000) and the basis we would use to calculate a gain ($695,000). In other words, the regulations tell us to use a basis in calculating a loss that would result in a gain (because $555,960 is greater than $495,000); but they also tell us to use a basis in calculating a gain that would result in a loss (because $555,960 is less than $695,000).
This is the kind of conundrum only tax lawyers love. And it is not one we've been able to find anywhere in any case that involves a short sale of a house or any other asset for that matter. The closest analogy we can find is to what happens to bases in property that one person gives to another. The Code tells us that the person receiving a gift generally takes the donor's basis in the gift as his own. Sec. 1015(a). But what if such a gift has a value lower than that basis when it is given? The answer that the Code and regulations give us for gifts is that the donee uses the lower fair market value to compute a loss but the donor's basis to compute a gain. Id.; sec. 1.1015-1(a)(1), Income Tax Regs. So far, so similar to the Simonsens' situation. But what to do when a donee sells the gift at a price between these two possible bases? The regulations on gifts tell us: Section 1.1015-1(a)(2), Income Tax Regs., provides that there's no gain or loss. "The no gain or loss answer derives from a conceptual vacuum when the asset is sold for an amount less than its gain basis and more than its loss basis." 1 Arthur B. Willis et al., Partnership Taxation 4-73, para. 4.03[2][c] (8th ed. 2017) (discussing the same odd result that must occur under section 1.165-9(b)(2), Income Tax Regs.) We know this regulation is for gifts and not converted personal residences. But we think it is logically coherent and adopt it as our holding today. We therefore conclude that the Simonsens realized neither a gain nor a loss on the short sale of their home.
 
#11
But, to say it has nothing to do with the OP's situation seems in error.
You're correct, the discussion you quoted does touch on the OP's situation. And the holding of the court was that in that gap situation the gain/loss is zero, the same result as I mentioned earlier:
So in that case, you have no gain on which to pay tax, but you have no deductible loss you can use to offset other income either.
I'm not surprised, as the court applied the same logic I did. It is really the only way for it to work. Whether it's the sort of rule only a tax lawyer could love, as Judge Holmes said, well, I'll not comment on that part. :)
 
#12
Thanks again for helping me with this. That link was an interesting read. I'm surprised that Publication 544 was not mentioned at all which I would have thought was relevant in this case though I suppose that the debt forgiveness from the short sale complicates this to the point where perhaps that publication is not quite applicable(?).
 
#13
Thanks again for helping me with this. That link was an interesting read. I'm surprised that Publication 544 was not mentioned at all which I would have thought was relevant in this case though I suppose that the debt forgiveness from the short sale complicates this to the point where perhaps that publication is not quite applicable(?).
The tax court and IRS attorneys will not cite IRS publications because those Publications are not legal authority. They are simply helpful guides to the public. There are some instances in which I disgree with the position the IRS has taken in publications and I advise my clients accordingly. As the publication is not legal authority, I'm free to take a different position so long as I can support it with legal authority (the tax code, tax regulations, IRS revenue rulings, court cases).
 
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