What IRS guidelines apply when converting a primary home to a rental property regarding depreciation and reporting?
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When converting a primary residence to a rental property, several IRS guidelines and rules apply regarding depreciation, basis, and reporting. Below is a comprehensive analysis of the relevant legal details, including the applicable Internal Revenue Code (IRC) sections, Treasury Regulations, and IRS guidance.
1. Depreciation Eligibility and Method
Depreciation Not Allowed for Primary Residence
- You cannot depreciate a primary residence because it is not used for the production of income.
Depreciation Allowed After Conversion to Rental
- Once the property is converted to rental use (i.e., held for the production of income), you are required to depreciate the building (not the land).
- The IRS requires the use of the Modified Accelerated Cost Recovery System (MACRS) for residential rental property, with a 27.5-year recovery period using the straight-line method.
2. Determining the Depreciable Basis
Basis for Depreciation at Conversion
- The basis for depreciation is the lesser of:
- The property's adjusted basis on the date of conversion (original cost plus improvements, minus any casualty losses or prior depreciation), or
- The fair market value (FMV) of the property (excluding land) at the time of conversion.
Land Is Not Depreciable
- Only the value of the building (not the land) is depreciable.
3. Depreciation Start Date
- Depreciation begins when the property is "placed in service" as a rental, i.e., when it is ready and available for rent, not necessarily when it is first rented.
4. Reporting Rental Income and Expenses
Rental Income
- All rental income must be reported on Schedule E (Form 1040) in the year received.
Deductible Expenses
- You may deduct ordinary and necessary expenses for managing, conserving, or maintaining the rental property, including mortgage interest, property taxes, insurance, repairs, and depreciation.
Improvements vs. Repairs
- Repairs are immediately deductible; improvements must be capitalized and depreciated.
5. Recordkeeping Requirements
- Maintain detailed records of rental income, expenses, improvements, and the property’s FMV at the time of conversion. This documentation is essential for substantiating deductions and calculating depreciation and gain or loss on sale.
6. Sale of Converted Property: Basis and Gain/Loss Calculation
Basis for Gain/Loss on Sale
- If the property is later sold, the basis for determining gain is the original cost plus improvements, minus depreciation taken.
- If the sale results in a loss, the basis is the lower of the adjusted basis or FMV at the time of conversion.
Depreciation Recapture
- Upon sale, any depreciation claimed during the rental period must be "recaptured" and taxed as ordinary income up to a maximum rate of 25% under IRC §1250.
Section 121 Exclusion
- If you meet the two-out-of-five-year ownership and use test, you may exclude up to $250,000 ($500,000 for married filing jointly) of gain on the sale of your main home, but this exclusion is reduced for periods of nonqualified use (i.e., rental use after 2008).
- Any gain attributable to depreciation taken after May 6, 1997, cannot be excluded and must be reported as unrecaptured Section 1250 gain.
7. Special Considerations
Mixed-Use Property
- If only part of the home is converted to rental (e.g., a basement apartment), only that portion is depreciable. The business portion must be used exclusively for rental or business purposes.
Passive Activity Loss Rules
- Rental real estate is generally a passive activity, and losses may be limited unless you actively participate or qualify as a real estate professional.
8. Summary of Key Steps When Converting a Primary Residence to Rental Property
- Determine the date of conversion (when the property is available for rent).
- Establish the depreciable basis as the lesser of adjusted basis or FMV at conversion, excluding land.
- Begin depreciating the property using MACRS, straight-line, 27.5 years, mid-month convention.
- Report all rental income and allowable expenses on Schedule E.
- Maintain detailed records of all income, expenses, improvements, and the FMV at conversion.
- Upon sale, calculate gain or loss using the appropriate basis, recapture depreciation, and apply Section 121 exclusion if eligible, subject to limitations for nonqualified use and depreciation recapture.
In summary: When you convert a primary residence to a rental property, you must use the lower of the adjusted basis or FMV at conversion (excluding land) as the depreciable basis, depreciate the property over 27.5 years using MACRS straight-line, report all rental income and expenses on Schedule E, and keep detailed records. Upon sale, depreciation recapture applies, and the Section 121 exclusion for gain may be limited by periods of rental use and depreciation taken.
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