Basis of Rental Property vs. Fair Market Value


It is not uncommon for homeowners to consider converting their current home to rental property when purchasing a new home.  The reasons are varied, such as hoping for a better sales price by holding on to the property for a few years, or the existence of a strong rental market and a desire for an income stream as well as tax savings derived from allowable depreciation and other deductions associated with ownership of investment property.  Sometimes, homeowners will rent their residence as the result of temporary employment relocation, with the expectation of returning in only a couple of years.

For tax purposes, the converted residence becomes depreciable as rental property when it is placed in service, meaning the date it is ready and available for rent.  Depreciation is based on the useful life of the asset from the date placed in service until it is retired from service (for example, you move back into the residence.)  The useful life for residential rental property (and any improvements) is 27.5 years using the straight-line method.

Generally, the basis of the property for depreciation is your original purchase price including most of the settlement charges on the HUD closing statement plus the cost of any capital improvements (not repairs) made up through the “placed in service” date minus the value of the land.  For example, you purchased the home in 1998 for $320,000, incurring capitalized settlement costs of $7,500, replaced the roof for $4,000 and refurbished the kitchen for $30,000 resulting in an adjusted basis of $361,500.  You rent the house out in 2011 at a time when the fair market value is $450,000.  If we assume the portion of the purchase price for the land was 20%, or $64,000, the depreciable basis is $297,500.

Sounds great, right?  But what if your rental property is in a part of the country where residential real estate prices have taken a severe nose dive from the economy the past few years and comparable values for houses similar to yours are selling for $250,000.  Do you still get to depreciate your adjusted basis?

Not according to Internal Revenue Code sections 167 and 168.  These sections say that you must use the lower of the fair market value at the time the rental property is placed in service or the adjusted basis.  Under this rule, and using the example above, the basis for depreciating the building would be $200,000.

If you’ve recently converted a residence to rental property, please review your tax records to make sure the transaction was properly handled.  If you or a friend is in need of assistance preparing your tax returns or facing an IRS audit, I would be happy to assist them.  Feel free to refer them to me using the information below.