Posted by JHyre in Ohio on May 20, 1999 at 07:07:36:
To da Baze,
See Reg. 165-9(b), Property converted from personal use. The taxpayer may take a loss on the property BUT the basis used to determine the loss is the Lesser of: Ordinary basis (usually original cost) OR FMV at the time of conversion from personal to rental use. Thus, this guy’s basis is the LESSER of $135,000 (cost) OR $90,000 to $110,000, FMV at time of conversion into rental property. The low basis is further reduced for any depreciation taken while the house was a rental.
John Doe buys a house 4 years ago for $135,000. Over the last several years the property values in his area have declined, so now his house is worth only about $90,000 - $110,000. He wants to sell. When told that you can’t claim a loss on the sale of a personal residence, he replies “I’ll just call it a rental and claim it there.” Now, I know that he could try to sell the house on a L/O or could legimately turn the house to a rental and then claim the loss upon the sale. But, all he wants to do is say that for the 5 months that it’s been vacant “. . . well, I tried to rent it out but I had no takers, but it was still a rental.” I can’t locate the IRS code that says no dice on this, that there are regulations concerning the conversion of personal residence to rental property. If you can point me in the right direction, I’d appreciate it. Thanks.
My CPA told me this idea many years ago and it has worked for his clients. As Dave T posted below, it is a question of the character of the property at the time sold, which will have to be proven to the satisfaction of the IRS auditor if he is audited.
If he can legitimately show that it was a rental by having copies of ads, proof he moved out, etc etc, he may be able to get away with it.
Any loss on the sale of a personal residence is nondeductible as it is considered a “personal, living, or family” expense. [Secs 1001(c);262;1.262-1(b)(4);1.165-9(a)]
While converting a home into a rental makes the loss deductible [Sec 165(c)(1) and (2)], if rented for less than three years, it is unclear what is the length of time before a personal residence becomes a rental, although the antithesis is known – if the home is rented for less than three of the last five years before sale, Sec 121 considers it a personal residence. One argument for the taxpayer – how a residence is being used at the date of sale is of major importance in determining whether property is business or personal [US v Winthrop, (5 Cir. 1969), 417 F2d 905]. Therefore, the taxpayer must prove that the property is a rental when sold, and the conversion is not done for tax purposes only [William C Harriman, 17 TC 903(1951)].
If the residence is rented for more than three years, prior to the sale date, under Sec 121, it automatically converts to rental property.
The adjusted basis for determining loss for property converted from personal use is the smaller of (1) the fair market value of the property at the time of conversion, or (2) the adjusted basis of the property at the time of conversion. Therefore, loss created prior to conversion is still not deductible either at the time of conversion or at the time of sale [Sec 1.165-9(b)(2)].
So the guy was going to sell the house and pay the difference anyway? How bout this?
He sell the house with Owner financing, for a little more than FMV, say 100-120k, he takes the cash down and the cash he was going to put in as a loss and buys or creates some notes, ie, discounted notes. Use the Notes to pay down the property faster or reinvest into other Notes to offset the difference.
Run an amortization schedule on the current property and on the sell with a Contract for Deed. Put a prepayment penalty in the CFD until the amortizations catch up. Shouldn’t take long if the Interest on the current mortgage is low and the Interest on the CFD is high, 9-12%.