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Deductions When a Rental Property Is Converted to a Personal Residence

When a rental property is transformed into a personal residence, there are specific tax considerations that need to be taken into account. If you currently own a property that you rent out and are contemplating converting it for personal use, there are several factors you should be mindful of.   

Once the conversion takes place, certain expenses that were previously deductible as rental property expenses can no longer be claimed. These include costs associated with utilities, home insurance, and repairs. However, deductions for mortgage interest expense and property taxes will still be available and can prove beneficial if your itemized deductions exceed the standard deduction. It’s worth noting though that these deductions may have limitations depending on factors such as the amount of your mortgage loan (for interest deduction) or whether your overall state and local tax payments exceeded $10,000 (for property tax deduction). Moreover, there might also be additional credits accessible to you if you’ve installed solar systems or made energy-efficient home improvements.

The more intricate implications arise when the converted property is eventually sold. In this case, some or all of the gains from the sale may qualify for special treatment as a personal residence

Loss on Sale of a Personal Residence

In the event that you sell your personal residence at a loss, it is important to note that this loss cannot be claimed as a deduction. This is because nonbusiness losses, such as those incurred on the sale of a personal residence, are not eligible for deduction.

Exclusion of Gain on the Sale of a Personal Residence – The Ownership and Use Tests

If certain conditions are met, a single taxpayer may be able to exclude from income up to $250,000 of gain from the sale of a personal residence, while up to $500,000 of gain may be excluded on a joint return. The exclusion is allowed each time a taxpayer meets the eligibility requirements, but generally not more frequently than once every two years.

The general qualification for exclusion of gain on the sale of a personal residence is subject to two tests: the ownership test and the use test.

The ownership test requires that you have owned the home for at least two of the five years preceding the date of sale.

The use test requires that you have lived in the home as your principal residence for at least two years during the five-year period ending on the date of sale.  This period does not have to coincide with the two-year period that meets the ownership test.  For example, you may have rented and lived in the property for two years and then purchased the property from the landlord.  Then you could have rented out the property for the next two years before selling it.  You would have met the use test for the two years you rented the property from the previous owner.  And you would have met the ownership test for the two years before the sale while you were renting the property.  Thus, the sale qualifies under the ownership and use tests.

If you are married, to qualify for the $500,000 exclusion, either you or your spouse may have been the owner during the testing period, but both of you must meet the use test.

If you originally acquired the home through a tax-deferred exchange, then you (or your spouse, if married) must own the home for at least five years before the home sale exclusion can be used, provided you (and your spouse, if married) also meet the 2-year use test.

Partial Gain Exclusion

If the ownership and use tests are not met, the sale of a personal residence may still qualify for a partial exclusion of gain if the reason for the sale was work-related, health-related, or triggered by an unforeseen event.  IRS Publication 523 provides details on how to determine each of these situations.

A job-related move includes: 

1. A new job that is at least 50 miles farther from your home than your previous job; or
2. If there is no previous job, a new job that is at least 50 miles from your home; or
3. Any of the above for your spouse, a co-owner of the home, or anyone else for whom the home was a residence.

A health-related move includes:

1. A move “to obtain, provide, or facilitate the diagnosis, cure, mitigation, or treatment of illness, disease, or injury for yourself or a family member.
2. A move “to obtain or provide medical or personal care for a family member suffering from an illness, disease or injury. A family member includes your
   1.  Parent, grandparent, stepmother, stepfather;
   2. child (including adopted child, qualifying foster child and stepchild) or grandchild;
   3. brother, sister, stepbrother, stepsister, half-brother, half-sister;
   4. mother-in-law, father-in-law, brother-in-law, sister-in-law, son-in-law, daughter-in-law; or
   5. uncle, aunt, nephew or niece”.
3. You moved on the recommendation of a physician because of a health problem.
4. “The above applies to your spouse, a co-owner of the home, or anyone else for whom the home was their residence”.

Any of the following that occurred while you owned and lived in the home is considered an unforeseeable event:

1. The home was destroyed or condemned.
2. A natural or man-made disaster or act of terrorism caused a casualty loss to your home, whether or not the loss is deductible on your tax return.
3. Anyone for whom the home was a residence:
   1. Died.
   2. Divorced, legally separated, or has been ordered to pay alimony to the other spouse.
   3. Gave birth to two or more children from the same pregnancy.
   4. Became eligible for unemployment benefits.
   5. Became unable to pay basic living expenses due to a change in employment status (basic living expenses include food, clothing, shelter, medicine, transportation, taxes, court payments, and expenses reasonably necessary to earn an income).
4. Published IRS guidance defines an event as unforeseen.

Even if a situation doesn’t fit these specific classifications, it may still qualify for a partial exclusion of gain if it occurs while you own your home, you sell the home shortly thereafter, you couldn’t have reasonably foreseen the event when you bought the home, you had financial difficulty maintaining the home, and/or the home became substantially less suitable for you and your family for a specific reason.

If a sale qualifies, the partial exclusion is calculated using the shortest of:

1. The number of days or months you lived in the home during the last 5 years;
2. The number of days or months you owned the home immediately before the sale; or
3. The time between the sale of the home and the last time you sold a home for which you claimed a personal residence exclusion.

Divide the smallest of these periods by 730 (if calculated in days) or 24 (if calculated in months).  Multiply the result by $250,000.  If the property is sold and you are married and filing jointly, do the same calculation for your spouse and add the two results to determine the maximum amount of gain you can exclude from income.

The effect of a rental period after 2008

A special rule enacted in 2008 requires the proration of gain on the sale of a personal residence that was not originally used as a personal residence.  To determine the maximum gain exclusion for the property, the percentage of time the property was used for a non-qualifying use (such as a rental) must be taken into account.  For example, if a property was purchased after 2008 and rented for 2 years before being converted to a personal residence, the gain exclusion amount must take into account those 2 years of non-qualifying use to determine the maximum gain exclusion available.  For example, if the property was sold after being owned for 5 years, then the maximum exclusion amount is 60% of the $250,000/$500,000 exclusion figures since the property was a personal residence for three of the five years it was owned.

Depreciation Recapture

The sale of a residence that has been converted from rental to personal use triggers the recapture of depreciation claimed during the time the property was used as a rental.  This recapture is reported as ordinary income on the tax return for the year of sale and is taxed at the taxpayer’s highest tax rate, up to a maximum of 25%.

Reporting the sale

The sale or exchange of your principal residence is reported on Form 8949, Sale and Other Dispositions of Capital Assets, if

•  You have a gain. The gain is not fully excludable from income,
•  You have a gain and you elect not to have it excluded from income, or
•  You have been issued a Form 1099-S, Proceeds from Real Estate Transactions. This form is prepared by the settlement agent, such as a title company or attorney, and issued to you with a copy to the IRS.

Even if you don’t receive a Form 1099-S and the gain is fully excludable, it may still be wise to report the sale on Form 8949 so that there is a record of the transaction for income tax purposes. 

If you are considering the conversion of a rental property into a personal residence, we can help you determine the tax implications in advance.  Please call for assistance.