Conversion of a secondary home to a rental property.?

Question

I bought a home 8/02 (400K) and lived in there until 8/04. It remained a second home (my parents lived there for free). I know my 5 yrs will be up in 8/07 to get my tax free gain (worth about 700K) , but in case I cannot sell it, I want to convert it to a rental.
1) What is my basis for the property if I convert in 8/07 for example?
2) If I sell in 10/08, how will I be taxed and what will be my basis or gain? Long term rate? I live in California.

Answer 1

Your basis for depreciation purposes when you convert it will be the lower of:

1. Your cost plus the cost of any improvements, less the value of the land.
2. The Fair Market Value when you convert it, less the value of the land.

Your basis for capital gains purposes when you sell will be your cost, plus the cost of any improvements, less any depreciation allowed or allowable when you were renting the property out.

Since you will not meet the 2 of 5 rule if you sell it after 8/07, the entire gain will be taxable as a long term capital gain. The tax rate is normally 15% for most taxpayers but depending upon your marginal rate can vary from 5% to 28% in some cases.

Answer 2

2

Answer 3

Your basis for the property will be $400k plus improvements you made prior to converting the property to business use. The basis for depreciation does not include the value of the land, which I will ignore. This assumes the improvements are less than $300k.

Let's assume for answering the second question that your basis is $400K and you sell the property for $700k.

If you convert to rental and then sell it in 2008, you no longer have any exclusion for the sale of a principal residence. Your basis is reduced by the amount of depreciation you took in 2007 and 2008, conservatively $15k, so say $385k. You would pay 15% long-term capital gains on $315k, or about $47k.

State taxes are in addition to the above.

Answer 4

If you convert the property to a rental your adjusted basis will be 400k plus any improvements that you made since 8/02. If you sell the property in 10/08 your gain will be the difference between the above adjusted basis and the sale price minus the cost of sale. Your Federal rate will be 15% and the CA rate could be as high as 9.3% as CA does not have a capital gain rate, everything is taxed as ordinary income. If you knew that you were going to sell it in 10/08 you should go live in the house as your primary residence starting in 07/07. The two years do not need to be continues.