Miscellaneous Tax Items Relating to Rental Income
There are a variety of miscellaneous tax items, such as passive credits and converting a home to a rental property, that relate to rental income. These are outlined below.
Passive Credits
Convert credits into a “deduction equivalent;” then this figure is subject to the same general rule as the losses themselves.
Casualties and Passives
A casualty loss to a passive activity will be “recharacterized” as non-passive, and thus, it is fully deductible.
Local Transportation
A taxpayer who owns rental property may be able to deduct ordinary and necessary local transportation expenses if the expenses are incurred to collect rental income or to manage, conserve, or maintain the rental property. However, transportation expenses incurred to travel between the property owner’s home and a rental property generally constitute non-deductible commuting costs unless the landlord’s home is used as his or her principal place of business. (Pub 527, 2021, page 4) For eligible expenses either the standard mileage rate or the actual expenses method can be used. The same record keeping requirements apply as for deducting business use of a vehicle.
Converting a Home to a Rental
It is not uncommon to have a client convert a personal residence to a rental property. Some even think if they convert to rental use a home that has declined in value, they can then deduct a loss when they sell the property, which is not the case.
When a residence or other non-business property is converted from personal use to business or income-producing use, for purposes of calculating losses or depreciation (but not gain), the basis for the property on the date of its conversion is the lower of its adjusted basis or fair market value on that date (Regulation Sec 1.167(g)-1).
However, for purposes of computing gain, the basis continues to be the adjusted basis at the time of the conversion (Reg § 1.165-7(a)(5); Reg § 1.165-9(b); Reg § 1.167(g)-1). Thus, for property converted from personal use to business use, the conversion has created a dual basis for the property:
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For computing a loss: if the sale results in a loss, the basis is the lower of the FMV or the adjusted basis at the time of conversion.
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For computing a gain: if the sale results in a gain, the basis is the adjusted basis at the time of conversion.
A sale of converted property where the sales price is more than the basis for loss but less than the basis for gain results in no gain or loss. When converting personal use property to business use, the FMV of the property can be a very important factor. If challenged, the IRS will want to know how the FMV was determined and will require more than a guess. They often require a certified appraisal. Taking short cuts can lead to problems in the future.
Sale of Converted Residence
What is the treatment when a residence is converted to a rental and then sold at a loss? When property that was purchased for and used for residential purposes is converted to rental or business use, it loses its character as a residence and becomes business property. When a personal residence is converted to a rental, the property's basis at the time of conversion for computing loss or depreciation is the lesser of the property's adjusted basis or its fair market value. As a result, a taxpayer cannot rent out what was his personal residence for a time before selling it and expect to claim a loss that would otherwise not have been deductible if he’d continued to use the home as his personal residence. To deduct a loss on the sale of a residence, a taxpayer must actually rent the property at a fair rental price before it is sold. (Newcombe v. Commissioner, Dec. 30,178, 54 TC 1298)
Example – Lisa purchased a residence for $140,000, lived in it for a few years and then converted it to a rental. At that time the FMV was $115,000. If she had sold it instead of turning it into a rental, the loss would not have been deductible. After conversion, Lisa claimed $7,800 of deprecation during the time it was used as a rental. She sold it after a few years for $95,000. Her depreciable basis at the time of the sale was $107,200 ($115,000 – 7,800). Her loss is not $45,000 ($140,000 - 95,000), but $12,200 ($107,200 – 95,000). Effectively the loss sustained while Lisa used the property as her personal residence is excluded. Further, because the loss is limited by the FMV at the time of the conversion, if Lisa fails to prove the value at that date, any loss deduction is barred.
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Easements
Easements can be permanent or for a period of time. Where they are for a specific period of time, the payments for easements are generally rental income (Wineberg, William, (1961) TC Memo 1961-336), but see GCM 35492 (9/73) for a different outcome). For the tax treatment of permanent easements see the guide "Basis".