Rental vs Home Exclusion

[Zee]

Home sales & prices seem to be continuing downward. The gains from selling a home used as a residence for two years are also much less than three short years ago. After paying commissions, there could even be a small loss. In addition, there's a surplus of rental property on the market and rents are lower than ever. I'm interested in the best strategy for a client with home used as their primary residence and purchased just two years ago. They'll be almost break-even after paying real estate fees if they sell at full list, if discounted there might actually be a loss. Also, the house might sit in inventory for some time because of the homes on the market. It's also doubtful it could be rented for a break-even amount, but the cash inflows might help offset the costs of holding two homes.
So, what's my question? If the property is advertised for rental at fair market value rental, when does it become rental property? And, is there a time period it must have been rental property before a loss can be taken on the sale? I'd appreciate any suggestions you might have.

[MAMalody]

<<<If the property is advertised for rental at fair market value rental, when does it become rental property? And, is there a time period it must have been rental property before a loss can be taken on the sale? I'd appreciate any suggestions you might have.>>>

In my opinion, a rental is a rental when it becomes a rental, which would normally be when it is ready to rent and it is being held available for rent and advertised as such. Be advised, that if it does not rent, it could be that you are not charging the fair rental price and the IRS could disallow as not really being available for rent. Once it is a rental all the normal rental rules would apply.
Mike

[Zee]

Rental

Mike - With the surplus of rentals in today's market, it can be very difficult of find renters even if advertised at a reasonable FMV for the rental. As such, a property could very likely still not rent at FMV. So, why not advertise the property for rental thru the selling broker at the same time it's being offered for sale and convert the possible future loss to a deductible loss, and benefit from deducting the rental expenses during the same period?

[Gretel]

If the intention is selling the home and not renting, it never is a rental unless actually rented for some time. What this "some time" is? I don't know, but it needs to have some substance. IRS is not stupid.

Everyone could find a relative or friend "to move in" for 1, 2 or even 3 months and "pay" rent. The longer the period, the better.

[DTS]

???

Zee,

I'm a little confused at your question. Are you trying to take a loss for a personal residence under the guise of rental property or are you trying to sell the property, but don't want to because the 121 won't be as high as wanted or are you converting to rental property until a time when market prices improve?

If converting to r/p, it's my understanding it's a rental at the time it's available to rent. Whether it rents right away or not does not matter, as long as an effort can be shown you are actively trying to rent the property.

Dennis

[Roland Slugg]

Get an appraisal

Dear Zee

If the home is converted to a rental, the basis for depreciation and for the purpose of figuring loss is the lower of: (1) its basis for figuring gain, or (2) its FMV as of the date it was converted to a rental. (Regs §1.167(g)-1) This prevents built-in non-deductible losses from being converted into deductible §1231 losses.

For most residences this is never an issue, but in a period of declining values it can become one, as your question illustrates. Clients who plan to convert a residence into a rental when its FMV has declined below its cost basis should obtain a bona fide, written appraisal from a qualified appraiser.

[Zee]

Thanks for the input. First, let me address the question on whether I'm attempting to create a "sham" rental, or not. The home is in Florida and (like elsewhere) in a declining market. The problem is inventory for sale and rental. Investor's hoping for an upturn have saturated the rental market, while continuing to try and sell their investment property. So, it's really a classic case of supply/demand. After selling expenses, a quick sale would at best break-even because of the timing of the purchase (not the high point, but midpoint). In addition to investor's, there are lots of individual sellers that are attempting to still get a handsome profit and leave because of insurance costs, hurricanes, etc. This has created a substantial excess amount of supply vs demand. As such, the house might have to remain on the market a year or more before it can be sold. Rental pricings is also at an all-time low because of the excess inventory and most rentals here in Florida are for furnished homes. So, it's highly unlikley the home will rent even if offered at an arms-length FMV for the rent. Bank appraisals have not caught up to the market place. Don't ask me why. The house was appraised for a line of credit at $30,000 more than the listing price. It will never sell for that amount unless the market sees double-digit gains again soon. If the homeowner lists the home with a property manager for rental and a FMV rental amount, it would seem me it then qualifies as rental property. I don't see any reason the property can't be offered for rental or sale at the same time (I suspect that happens all the time), but would agree it might look like the "intent" is simply to create a loss situation. If the basis for loss becomes the FMV on the date of the conversion to rental property, we're probably right back to the cost basis for FMV. The loss would be created by the selling expenses. This market situation is unusual. It would be nice to find a way to help the client meet the expenses of holding a second home until either the market recovers, or he sells.

[Bees Knees]

I don't see any reason the property can't be offered for rental or sale at the same time (I suspect that happens all the time), but would agree it might look like the "intent" is simply to create a loss situation........It would be nice to find a way to help the client meet the expenses of holding a second home until either the market recovers, or he sells.

What if someone actually takes you up and wants to rent it?

Does your client really want to be in the rental business?

What if they let someone move in, and the renters start to trash the place?

Then what will happen to the already decline in selling price?

Maybe there are reasons other than a small tax deduction for not wanting to go the rental route.

[Zee]

What if someone actually takes you up and wants to rent it?

Does your client really want to be in the rental business?

"I doubt it, but they sure would like to find a way to deduct some of the expenses of ownership until it sells".

What if they let someone move in, and the renters start to trash the place?

"That's certainly a risk, but can be somewhat reduced by interviewing renters".


Then what will happen to the already decline in selling price?

"I guess that depends on how well the property is maintained, but adding age to a 2-year old home, doesn't help either".

Maybe there are reasons other than a small tax deduction for not wanting to go the rental route.

Good point. But, the upkeep of a distant second home can be every expensive. I recently sold a home that was on the market for 8-months. The montly upkeep was quite high (excluding the mortgage payment). I don't think investors like the idea of renting new homes either, but sometimes it's the least of evils. Also, I'm not sure how you'd define a small tax deduction. Let's assume the loss is $25,000, or more? Is that small?

[MAMalody]

So, it's highly unlikley the home will rent even if offered at an arms-length FMV for the rent. Bank appraisals have not caught up to the market place. .

You should note that when a property does not rent over a period of time, the IRS can take the position that is NOT at Fair Rental Value. The fact that other similiar properties are priced at a similiar property does not establish Fair Rental Value. Fair Rental Value is market driven, not client wishes for a break even point.

You are correct about the dual rental/sale position being fairly common. When I was an auditor that forced me to make a decision on what was going on. The prior questions are critical to support your position, whatever it might be.

Mike

[WhiteOleander]

It can also be very difficult to get insurance on a vacant house. Insurers really don't like that.

[Bees Knees]

Also, I'm not sure how you'd define a small tax deduction. Let's assume the loss is $25,000, or more? Is that small?

In my area, rental property is perceived to be less valuable than property used as an owner occupied home. That is because rental property is not viewed as being in as good condition as non-rental property.

I don’t know the percentage difference, but a 5% reduction in FMV might not be out of line.

If you have a $25,000 loss on the sale of personal use property, that is a non-deductible loss. You didn’t mention the sale price, but lets just pick a number…say $250,000. That would mean you are selling it for $250,000 with a cost basis of $275,000 for a loss of $25,000 that you cannot deduct. Your client comes away with $250,000 cash after the sale.

Now you want to help your client by turning it into rental so that the $25,000 loss will generate a tax savings. Someone in the 25% tax bracket will save $6,250 in taxes. But wait…in order to do that, you have to turn the property into rental, which could automatically reduce the perceived FMV by $12,500 (5% of $250,000). Now you sell it for $237,500 which generates a $37,500 loss, which generates a tax savings of $9,375. After tax savings cash equals $246,875 ($237,500 + $9,375).

Which would your client rather have? $250,000 cash without deducting the loss, or $246,875 cash after deducting the loss and saving on taxes?

[Armando Beaujolais]

Since basis will be lower of FMV or adjusted basis at the time of conversion to rental property, the only way you could recognize a loss is if the property continues to decrease in value over time.

If the property value is going to continue to fall, you're better off selling it at a loss now instead of selling it at a loss later after several months of maintenance costs.

If you convert the property to investment property, and it goes up in value, taxable gain.

I think your best bet is to make a decision and go for it. You can convert the property to investment property and start exhibiting all the behaviors, or you can keep the property as personal-use property and try to sell it. The danger exists if you're going to try to ride the fence and make a choice when you see which way the market is going to cut.

There's no bright line test to determine when the property becomes investment property.

Before the section 121 rules changes, there was a 2-year qualified rental period for this exact situation, where you could rent out a personal residence for two years and still exclude the gain. That rule went away, and as far as I know, it hasn't been replaced by anything. That means you're going with a facts and circumstances deal, which means you stack up the behavioral facts and circumstances in your favor.

It might be a good idea to price it to sell and run away. Trying to get fancy in a situation like this could be fraught with peril.

[Jan]

Before the section 121 rules changes, there was a 2-year qualified rental period for this exact situation, where you could rent out a personal residence for two years and still exclude the gain. That rule went away, and as far as I know, it hasn't been replaced by anything. That means you're going with a facts and circumstances deal, which means you stack up the behavioral facts and circumstances in your favor.

.

Can't you still use the property as rental for 3 years and 2 years as resident and still qualify for 2 out of the last 5 years as residents?

[Zee]

In my area, rental property is perceived to be less valuable than property used as an owner occupied home. That is because rental property is not viewed as being in as good condition as non-rental property.

I don’t know the percentage difference, but a 5% reduction in FMV might not be out of line.

If you have a $25,000 loss on the sale of personal use property, that is a non-deductible loss. You didn’t mention the sale price, but lets just pick a number…say $250,000. That would mean you are selling it for $250,000 with a cost basis of $275,000 for a loss of $25,000 that you cannot deduct. Your client comes away with $250,000 cash after the sale.

Now you want to help your client by turning it into rental so that the $25,000 loss will generate a tax savings. Someone in the 25% tax bracket will save $6,250 in taxes. But wait…in order to do that, you have to turn the property into rental, which could automatically reduce the perceived FMV by $12,500 (5% of $250,000). Now you sell it for $237,500 which generates a $37,500 loss, which generates a tax savings of $9,375. After tax savings cash equals $246,875 ($237,500 + $9,375).

Which would your client rather have? $250,000 cash without deducting the loss, or $246,875 cash after deducting the loss and saving on taxes?

I'm not sure the 5% FMV difference is valid here. In fact, fully rented property might be worth more to an investor, not necessarily less. Of course, it might be best to rentwith the hopes the market will recover in the next 12-18 months. The out of pocket cost of holding the property is about $2100 month (including utilities & maintenance). The tax benefit of renting would be significant to this taxpayer.

If the property is rented for 18-months and later sold at a gain, I assume the gain can be excluded given the 2 years out of rule residency rule, etc. Is that correct?