Temporarily converting a personal residence to income-producing property.

• Author: Martin, Vernon M., Jr.

When a homeowner decides to be away from his personal residence for an extended period of time and rents the home during his absence, a number of tax-related issues arise. This article will discuss those issues, including the difference between a personal residence and rental property, capitalization, deduction or nondeduction of costs, the difference between the hobby loss rules and the passive activity rules, and the sale of a personal residence versus the sale of income-producing property.

Converting a Personal Residence

to Income-Producing (Rental) Property

Sec. 280A(a) refers to a personal residence as a "dwelling unit," which in turn is defined in Sec. 280A(f) as "a house, apartment, condominium, mobile home, boat, or similar property...." The regulations under Sec. 1034 further state that the personal residence of a taxpayer "depends upon all the facts and circumstances in each case, including the good faith of the taxpayer."(1) Therefore, if a taxpayer is actually living in a house with the intent that the house be his primary residence, it generally is the taxpayer's personal residence for Federal tax purposes.

The term "dwelling unit" is also included in the definition of "residential rental property" in Sec. 168(e)(2)(A): "[A]ny building or structure if 80 percent or more of the gross rental income ... is rental income from dwelling units." A "dwelling unit" is further defined in that same Code section as "a house or apartment used to provide living accommodations in a building or structure...."(2) Therefore, if a taxpayer transfers his personal residence to another location, intends to turn the previous dwelling unit into income-producing property, and rents the previous residence at a fair market value (FMV), the previous residence has been transformed from a personal residence to income-producing property.

The Federal Income Tax Implications

of a Conversion

* Depreciation

Depreciation (or "cost recovery" as it was termed in the Economic Recovery Tax Act of 1981 (ERTA)) is one of the first items to be considered when considering rental expenses. Depreciation is "a reasonable allowance for the exhaustion, wear and tear (including a reasonable allowance for obsolescene) ... of property held for the production of income."(3) The amount of depreciation under Sec. 167(a) is determined by using a specific method, a specific life ("applicable recovery period") and a specific convention.(4) The only method of depreciation available under the Tax Reform Act of 1986 (TRA) for residential rental property purchased and placed into use after Dec. 31, 1986 is the straight-line-method;(5) the only life available is 27.5 years;(6) and the only convention available is the mid-month convention, which assumes that all property is placed in service at the midpoint of the month, thereby allowing one-half of a month's depreciation in the first month.(7)

The depreciation expense for any given year is determined by taking these three items and applying them to the property basis. Basis for depreciation is the adjusted basis determined under Sec. 1011.(8) Sec. 1011 refers to Sec. 1012, under which the basis of property begins with cost. Therefore, the original cost of a given property is the place to start in the determination of basis.

* Adjustment to basis

Adjustments to basis are determined by Sec. 1016. Expenditures that increase the value of life of a dwelling unit are capital expenditures ("chargeable to capital account") and increase the basis; e.g., a room or garage addition...