In this economy it can difficult, if not impossible, to sell your home for a price you can swallow. So you might be thinking about renting it out until the local market improves especially if you ve already bought another home and are now paying two mortgages, along with a double helping of all those homeownership costs (property taxes, etc).

However, converting a former personal residence into a rental property has some tricky tax implications that may come back to haunt you when you finally sell the property. And, as you will see, knowing your home s fair market value on the day you convert it to a rental is very important.

Determining Your Tax Basis When Claiming a Loss

You may already know that you can t claim a tax loss when you sell a personal residence for less than your tax basis in the property. In most cases, the tax basis equals the original purchase price plus the cost of any improvements (not counting normal repairs and maintenance), minus any depreciation deductions (say from a deductible office in the home). The privilege of claiming tax losses is reserved for sales of property used for business or investment purposes. Sorry.

But if you convert your home into a rental and eventually sell it for less than the tax basis, you can deduct the entire loss, right? Nope. A special basis rule prevents that taxpayer-friendly outcome.

The special rule says that when you convert a former residence into a rental, your initial tax basis for calculating any later loss on a sale equals the lesser of: (1) the property s basis on the conversion date under the normal rule, or (2) the property s fair market value (FMV) on the conversion date.

In effect, the special rule disallows the loss from a decline in value that occurs before the conversion date. But a post-conversion decline will result in an allowable tax loss to the extent it s not offset by depreciation write-offs. (Because depreciation lowers the property s tax basis for loss purposes, it makes it harder to have a loss.)

To calculate depreciation deductions on the converted property, you will have to use the same unfavorable special basis rule to figure your initial tax basis. (You can depreciate basis allocable to the building not the land over 27.5 years.)

Tax Basis for Gain Purposes Is Different

Say the value of the converted property recovers, and you sell for a profit down the road. The property s tax basis for gain purposes is determined under the normal basis rule, which, as I said earlier, usually equals the purchase price plus the cost of improvements minus depreciation, including depreciation while the property is rented out.

If you have a tax gain, it will usually be federal-income-tax-free (under the $250,000/$500,000 gain exclusion break) if the sale occurs fewer than three years after you convert the home into a rental. (Read more on this here

Different Basis Numbers Can Create Unexpected Results

Since the special basis rule for tax loss purposes is different than the normal basis rule for tax gain purposes, you can potentially wind up in no man s land where you have neither a tax gain nor a tax loss. That will happen if the sale price falls between the two basis numbers. Confusing? You bet. To clarify matters, here are some examples that illustrate the tax results that will occur with differing conversion-date FMVs and differing sale prices.

Scenario 1: Tax Loss on Sale
Say the property s tax basis under the normal rule is $300,000, but its fair market value on the conversion date is $235,000. You eventually sell the house for $205,000 after claiming $13,000 of depreciation write-offs during the rental period.

The result: There is an allowable tax loss because the sale price is considerably lower than the conversion-date value. (See below for the details.)

Scenario 2: Tax Gain on Sale
Now consider a property with a $300,000 tax basis under the normal rule, but a $285,000 FMV on the conversion date. Depreciation deductions during the rental period total $16,000. The house appreciates somewhat after the conversion date, and you eventually sell for a net price of $295,000.

The result: You would actually end up with a tax gain, caused by the post-conversion depreciation deductions.

Scenario 3: No Tax Gain or Loss
Finally, assume the property s tax basis under the normal rule is $300,000, the FMV on the conversion date is $235,000, and you claim $13,000 in depreciation write-offs. After the market improves somewhat, you sell for $260,000.

The result: Surprise! There s no tax gain or loss because the sale price falls between the two basis numbers.

The Bottom Line

I wish this was simpler, but it s not. An important thing to remember is that the property s FMV on the conversion date is often the most important factor in determining the tax results from a later sale. So make sure you have some evidence of the FMV, like a market evaluation from a local realtor. Keep it with your tax records. For more on the tax implications of owning rental real estate, please see my other articles, "So You Want To Be a Landlord" and "Tax Breaks for Losses on Rental Property Sales."