by Karl P. Baker, Esq.1
Given how long it has been since the last sustained drop in residential real estate values, many homeowners and attorneys are likely to be unfamiliar with the income tax implications of a declining real estate market.2 A basic understanding of these issues, however, is important to homeowners struggling to decide how to address devalued real estate assets.
Selling a personal residence that has declined in value
While owner-occupied real estate is widely regarded as receiving preferential tax treatment,3 there is certainly no favoritism when it comes to selling a personal residence that has declined in value. While investors can deduct losses on other investments, losses on the sale of property used as a personal residence are not deductible.4 This disparate treatment apparently owes to the seemingly quaint notion that “use of property solely as a personal residence is antithetical to its being held for investment.”5
Some homeowners may also be faced with the realization of taxable income upon a short sale or foreclosure of a devalued asset on the theory that they have “income” in the amount of the discharged indebtedness.6 While the Mortgage Forgiveness Debt Relief Act of 2007 limits the extent of this problem, it only excludes from taxable income discharges of acquisition indebtedness on a principal residence.7 Thus, homeowners may still be assessed income tax liability arising from the discharge of indebtedness related to second homes, or indebtedness associated with cash-out refinancings.8
Conversion of personal residences to rental properties
Confident or hopeful that the market will recover sometime in the near future, some homeowners desiring to move to a different city or house may decide to rent their existing home, rather than sell it. In addition to being familiar with a landlord’s legal obligation to tenants (e.g. fair housing law, regulations governing the handling of security deposits, etc.), these homeowners need to understand the income tax consequences of such a conversion.
Homeowners with significant built-in gains should be most concerned with how a conversion may affect their ability to exclude gains from income when they sell the property. Under IRC § 121, up to $250,000 in gains ($500,000 for joint returns) are excludable from the sale of a property that “has been owned and used by the taxpayer as a principal residence for periods aggregating two years or more” in the five years preceding the sale or exchange. Thus, taxpayers who have owned and lived in a home continuously for two years can safely rent the property so long as they eventually sell it within three years. Beyond three years, some homeowners may still be able to exclude some of the gains from the sale of the property for two additional years, if the sale or exchange is deemed to have been “by reason of a change in place of employment, health, or, to the extent provided in regulations, unforeseen circumstances.”9 Detailed regulations describe the situations where a sale or exchange would be deemed to have been precipitated by these circumstances. These include safe harbors, such as one that deems a sale to be “by reason of a change in place of employment” if the homeowner changes their place of employment, while owning and living in the home, to a location more than 50 miles farther from the residence than a former place of employment.10
Homeowners with little or negative appreciation in their principal residences have a different set of concerns. As noted, losses on the sale of a personal residence are not deductible. While losses on the sale of rental properties are deductible from ordinary income,11 this will not permit homeowners to deduct for declines in value that occurred while the property was used as a personal residence. This is because when a loss is claimed on a property converted from a personal residence to a rental property, the basis of the property upon conversion is set according to the market value on the date of the conversion, or the adjusted basis in the home, whichever is less.12 Thus, if Alex purchased a home in 2005 for $100,000, converted that home to a rental property in 2007 when the market value was $80,000, and then sold it in 2010 for $60,000, he would be able to claim $20,000 in losses. On the other hand, if Ben purchased a home for $70,000 in 2000, converted that home to a rental property in 2007 when the market value was $80,000, and then sold it in 2010 for $60,000, he would be able to claim only $10,000 in losses.13 For purposes of computing gain on the sale of a converted property, the basis upon conversion would be the actual cost basis in the personal residence on the date of conversion. Thus, to the extent a property appreciates after the date of the conversion back up to the original cost basis, this appreciation would not be taxed, except to the extent of depreciation recapture.
In considering a conversion of a principal residence into a rental property, homeowners should also be aware of the risk that this action would cause them to lose the protections of the Mortgage Forgiveness Debt Relief Act of 2007, which only excludes from income the discharge of indebtedness on a primary residence. This risk should be of most concern, of course, to homeowners that have little or no equity in their homes and may lack the financial capability to “weather the storm” if a tenant vacates or some other imbalance in the cost of maintaining the property and the income generated by it should arise.
1. Baker is an associate with Robinson & Cole LLP’s LandLaw Section. Baker graduated cum laude from Harvard Law School and holds a master’s degree in city planning from MIT.
2. The recently adopted tax credits for homebuyers are not a subject of this article.
3. The deductibility of mortgage interest for personal residences and the exclusion of $250,000 ($500,000 for married couples) in gain from the sale of a “principal residence” are the most widely cited evidence of this favoritism.
4. Treas. Reg. 1.165-9
5. See, e.g., Starker v. United States, 602 F.2d 1341, 1350-51 (9th Cir. 1979) (citing Treas. Reg. 1.165-9(a) and stating: “It has long been the rule that use of property solely as a personal residence is antithetical to its being held for investment. Losses on the sale or exchange of such property cannot be deducted for this reason.”).
6. IRC §1017.
7. Public Law No: 110-142; extended by Public Law No: 110-343, §303. Amendments codified at IRC § 108. This exclusion is also capped at $2 million and set to expire in 2012;
8. See id.; see also IRC § 163(h)(3) (defining acquisition indebtedness); IRC § 121 (defining principal residence).
9. IRC § 121(c). One should also be aware that the maximum exclusion phases out over two years for special exclusions falling outside the typical ownership and use test.
10. Treas. Reg. 1.121.-3
11. IRC § 1231. Subject to passive activity loss rules. See IRC § 469.
12. Treas. Reg. 1.165-9. There are no detailed regulations or guidance dealing with the issues of determining precisely when a property is converted from a personal residence to a rental property and how “fair market value” should be determined in this context.
13. These simple examples intentionally ignore depreciation on the rental property and any adjustments to basis that could have occurred during the period the property was used as a principal residence.