By: Martin M. Shenkman, CPA, MBA, JD
Clients may rent a portion or all of their houses to generate extra revenue. Another common planning technique can become quite costly if clients don’t maintain records. What if the clients wish to sell their principal residence and buy a new residence tax-free, but unfortunately the market where their old house is located is soft and they decide, perhaps with the advise of counsel, to wait a while to sell it? They might rent the house for a period of time pending the recovery of the local housing market. This might continue to grow in popularity in the aftermath of the sub-prime meltdown. Can they sell the house as a personal residence that qualifies for the exclusion after this rental period?
Under prior law the clients could have, within reasonable limits, pursued this temporary rental followed by sale as residence planning. They could have temporarily rented their old house to help cover the carrying costs while they waited for selling conditions to improve to maximize their selling price. They could have then sold the house and rolled over the gain tax-free into their new house. If, however, they had not occupied the house for too lengthy a period of time before the sale, the IRS may have argued that they abandoned it as their principal residence and the tax free rollover rules should not apply. Further, as explained above, the rental of a house will be deemed a period of non-qualified use and the gain allocable to the rental period will not qualify for the home sale exclusion benefits.
Take this planning scenario one step further. What if the clients convert a personal residence to rental use? If so, the clients will have to determine their tax basis in the property in order to calculate gain or loss on a sale, or depreciation while they rent it. The clients’ tax basis will be the lesser of the fair market value on the date of the conversion or their adjusted tax basis. Thus, records of tax basis should be maintained by all clients.
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