If You Cannot Sell... Rent

You've tried unsuccessfully to sell your home, and have run out of time. You're closing on your new home and cannot afford to pay two mortgages. Why not rent it out in the meantime?

You have the property and the location, and you can probably estimate pretty accurately what you can get for a reasonable rent. Depending on your situation, it may sound like a good idea, especially if you are having trouble selling your place. But proceed with caution because the IRS has managed to complicate the conversion of a home into rental real estate.

Those Nasty Tax Rules

The passive loss rules discussed earlier also apply to this type of rental property. But things get even trickier when it comes to figuring depreciation and the gain or loss on the sale of the converted home.

First, let's discuss depreciation. Even though your house may have gone up in value since you bought it, you are required to use the lower of the adjusted basis (cost plus improvements) or the fair market value of the home when you convert it to rental property as the basis for calculating depreciation. You will likely be stuck with the adjusted basis as the lower figure and you won't be able to take into account the appreciation on the home when computing depreciation expense. This method of computing depreciation expense applies even if you only rent out one floor or a single room in your home.

Here's an illustration of this concept:

Nicole purchased her home in 2001 for $260,000 and made improvements over the past few years costing $50,000. In 2008, she decided to convert the home to a rental property. The home is worth $360,000 in 2008. Assume land is valued at $60,000.

To compute the depreciation deduction she will claim against rental income, she must use the lower of the adjusted basis or the fair market value at conversion. In this case, she uses $250,000 as the basis for depreciation instead of $300,000.

What's the difference?

The annual depreciation deduction on $250,000 over 27.5 years is $9,100, while the annual depreciation deduction on $300,000 over 27.5 years is $11,000. She is not able to take advantage of almost $2,000 of deductions each year.