Question: I purchased a second residence several years ago which is now worth less than I paid for it. Can I convert the property to business use and report a tax loss?
Answer: Losses are not deductible on the sale of personal use assets such as a primary or secondary residence which is used strictly for personal purposes. This seemingly creates an incentive to convert property to business use for loss purposes and perhaps benefit from tax deductions for business expenses.
In converting personal use property to business use property, you must first establish an intent to maintain the real estate property as business or investment property. Renting the property at fair market value to a third party supports the notion that the property is business use property. While the creation of a rental relationship is a clear indication that the property is business use property, less definitive situations arise when a tenant cannot be secured for the property. In circumstances where a tenant cannot be found, documenting efforts to rent the property through advertising, engaging a real estate broker and other efforts may establish the business nature of the property for tax purposes.
When personal use property is converted to business use property, depreciation deductions may be claimed on the property after conversion. The basis for depreciation is the lesser of the fair market value of the property on the date of the conversion and the tax basis in the property which, under these circumstances, would be the purchase price. Ignoring for the moment the portion of the property allocable to land for which depreciation deductions may not be taken, if personal use real estate property is purchased for $300,000 and has a value of $200,000 on the date of conversion, the depreciable base of the property would only be $200,000. While deductions may be claimed for business expenses applicable to the property, depreciation deductions will be limited due to the decreased value of the property at the time of conversion.
Because the basis for tax purposes cannot exceed the property’s fair market value on the date of conversion, the decrease in the property’s value from the date of purchase cannot be deducted. Decreases in the property’s value following the date of conversion to business use property can be deducted.
The IRS imposes hurdles on the conversion of personal use property to business use property. Following the rules will permit you to claim business expenses applicable to the property after the conversion. Regretfully, the decrease in value between the time the property was purchased and the time the property was converted to business use property cannot be deducted for tax purposes.
The Tax Corner addresses various tax, estate, asset protection and other business matters. Should you have any questions regarding the subject matter or if you have questions you want answered, you may contact Bruce at (312) 648-2300 or send an e-mail to firstname.lastname@example.org.