How should I determine the depreciable basis for a former primary home that is now a rental property, considering the appraisal value at conversion?
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To determine the depreciable basis for a property that was formerly your primary residence and is now being used as a rental property, you must follow specific rules set out in the Internal Revenue Code, Treasury Regulations, and IRS guidance. The key principle is that the depreciable basis is not simply your original cost or your current adjusted basis, but is instead the lesser of your adjusted basis or the fair market value (FMV) at the time of conversion to rental use.
1. General Rule for Basis at Conversion
When you convert a personal residence to rental property, the basis for depreciation is the lesser of:
- The property's adjusted basis on the date of conversion, or
- The property's fair market value (FMV) on the date of conversion.
This rule is found in IRS regulations and publications:
- "The basis for depreciation is the lesser of the FMV of the property on the date you changed it to rental use; or your adjusted basis on the date of the change—that is, your original cost or other basis of the property, plus the cost of permanent additions or improvements since you acquired it, minus deductions for any casualty or theft losses claimed on earlier years' income tax returns and other decreases to basis."
- "If property purchased or constructed by the taxpayer for use as his personal residence is, prior to its sale, rented or otherwise appropriated to income-producing purposes and is used for such purposes up to the time of its sale, a loss sustained on the sale of the property shall be allowed as a deduction under section 165(a). The loss allowed under this paragraph upon the sale of the property shall be the excess of the adjusted basis prescribed in section 1.1011-1 for determining loss over the amount realized from the sale. For this purpose, the adjusted basis for determining loss shall be the lesser of either of the following amounts, adjusted as prescribed in section 1.1011-1 for the period subsequent to the conversion of the property to income-producing purposes: (i) The fair market value of the property at the time of conversion, or (ii) The adjusted basis for loss, at the time of conversion, determined under section 1.1011-1 but without reference to the fair market value."
2. How to Calculate Each Value
a. Adjusted Basis
The adjusted basis is generally your original cost (including certain acquisition costs), plus the cost of any capital improvements, minus any deductions for casualty losses, depreciation (if any), or other basis reductions taken before conversion.
- "The basis of property you buy is usually its cost. The cost is the amount you pay for it in cash, in debt obligation, in other property, or in services. Your cost also includes amounts you pay for: Sales tax charged on the purchase, freight charges to obtain the property, and installation and testing charges."
- "You must increase the basis of any property by the cost of all items properly added to a capital account. These include the following: The cost of any additions or improvements made before placing your property into service as a rental that have a useful life of more than 1 year."
- "You must decrease the basis of your property by any items that represent a return of your cost. These include the following: Insurance or other payment you receive as the result of a casualty or theft loss. Casualty loss not covered by insurance for which you took a deduction."
b. Fair Market Value (FMV) at Conversion
The FMV is the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having reasonable knowledge of relevant facts. This is typically established by a qualified appraisal as of the date of conversion.
- "FMV is the price at which property would change hands between a buyer and a seller, neither having to buy or sell, and both having reasonable knowledge of all necessary facts. Sales of similar property on or about the same date may be helpful in figuring the property's FMV."
3. Application of the Rule
- If your adjusted basis is less than the FMV at the time of conversion, use your adjusted basis as the depreciable basis.
- If the FMV is less than your adjusted basis at the time of conversion, use the FMV as the depreciable basis.
Example:Suppose you bought your home for $200,000, made $20,000 in improvements, and had no casualty losses. Your adjusted basis is $220,000. At the time you convert it to rental use, the FMV is $210,000. Your depreciable basis is $210,000 (the lesser of $220,000 or $210,000).
4. Allocation Between Land and Building
You cannot depreciate land. You must allocate the basis between the land and the building (and any other depreciable improvements) based on their relative FMVs at the time of conversion.
- "If you buy buildings and your cost includes the cost of the land on which they stand, you must divide the cost between the land and the buildings to figure the basis for depreciation of the buildings. The part of the cost that you allocate to each asset is the ratio of the FMV of that asset to the FMV of the whole property at the time you buy it. If you aren’t certain of the FMVs of the land and the buildings, you can divide the cost between them based on their assessed values for real estate tax purposes."
5. Depreciation Method
Once you have determined the depreciable basis, you depreciate the building (not the land) using the Modified Accelerated Cost Recovery System (MACRS), generally over 27.5 years for residential rental property, using the straight-line method and the mid-month convention.
6. Example from Regulations
Reg. §1.165-9(b)(2) and Example (1):- If the FMV at conversion is less than the adjusted basis, the FMV is used for depreciation.- Depreciation is computed on the value of the building at the time of conversion, not the land.- The adjusted basis for loss on sale is reduced by depreciation taken during the rental period.
7. Summary of Steps
- Determine adjusted basis as of the date of conversion (original cost + improvements – reductions).
- Obtain FMV of the property as of the date of conversion (preferably by appraisal).
- Use the lesser of adjusted basis or FMV as the starting point for depreciation.
- Allocate this amount between land and building based on their relative FMVs at conversion.
- Depreciate only the building (and other depreciable improvements) over 27.5 years using MACRS.
8. Citations
- IRS Publication 527, "Depreciation of Rental Property"
- IRS Publication 551, "Basis of Assets"
- Reg. §1.165-9(b) and examples
- IRS Publication 946, "How to Depreciate Property"
In summary: The depreciable basis for a former personal residence converted to rental property is the lesser of the adjusted basis or the FMV at the time of conversion, allocated between land and building, and only the building portion is depreciated.
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