Converting Owner-Occupied to Rental: Cost Basis?

[Nate_D]

I've owned a small 1br condo since 2007 (whoops).  I lived in it until 2010, when I changed cities and started renting it out.  It has been pretty much trouble-free since then, although I'm really just breaking even with the PITI vs. rental revenue each month, so it's a poor investment cashflow-wise.  I believe its value has rebounded somewhat over the past couple years, so I've been thinking of selling once my current long-term tenant decides to move out.

My understanding of the tax implications of selling is that the cost basis of the condo is the market value at the time it switched from owner-occupied to rental.  My problem is that I don't know how I should be calculating this value.  I remodeled the condo extensively immediately after buying it, which I assume would have increased its value (although probably not as much as I spent on the remodeling).  I understand that I can't directly factor the remodeling costs into the cost basis calculation, since they were incurred while the unit was owner-occupied and before the rental conversion occurred.

I refinanced the condo in 2011, so I have an appraised value from that particular point in time.  But I still really have no concrete idea of what the market value was in 2010 when the owner-occupied-to-rental conversion happened.  How much latitude do I have in determining this value?  It seems very open to interpretation.

Any advice would be much appreciated!

[Nate_D]

Thanks for the reply, Maigahane. To answer your question, I have been claiming the rental income and taking depreciation each year on my taxes. When I say I've been breaking even, that's been BEFORE depreciation is factored in.

Just to put actual numbers to this, I bought the condo in 2007 for $120k and spent about $30k on remodeling in 2008 (believe me, I have facepunched myself into oblivion on this). I do have receipts and invoices documenting the remodeling costs. So $150k total spent buying the condo and remodeling it.

Again, I don't know exactly what the fair market value was when I converted the condo from owner-occupied to rental in July 2010, but I know it was nowhere near $150k. All I really have to go off of are Zillow estimates, but of course those don't take into account the improvements I made in 2009.

Since the condo's FMV was undoubtedly less than $150k when I converted it to a rental, it seems that I have no choice but to take an educated guess at the FMV. Essentially, I would want to report the highest estimated FMV that would not trigger alarms with the IRS. I have no idea how they interpret or analyze these numbers so I really feel like I'm fumbling around in the dark here.

[Nate_D]

Ah, I see what you're saying.  The year I converted the condo to rental, I had an accountant do my taxes, and he ultimately went with the condo's purchase price ($120,000) as the basis for depreciation.  I can't remember what conversations we may have had about that, but I suspect he did it for simplicity, not knowing at the time how the drop in market values vs. the value of the remodeling work would shake out.  So I guess if the IRS has been okay with the $120,000 basis for the past several years, they should be okay with it when I eventually sell the place.

Thanks for the advice!

[Nords]

So I guess if the IRS has been okay with the $120,000 basis for the past several years, they should be okay with it when I eventually sell the place.

A few years is enough time for the IRS to notice the issue, if it's worth their time.  The IRS is not going to waste the salary of their highly-paid auditors arguing over the determination of your home's cost basis, especially when the difference is just a few thousand bucks. 

If you omit a form or make a mistake (like depreciating the land instead of only the value of the structure) then you'll get a query letter.  But answering the question (or admitting the mistake and paying up) is usually all the response that's required. 

Of course if you're committing tax fraud in some other way, then the pissed-off IRS will take the extra steps to punish you for every little innocuous mistake on your taxes-- including the cost basis of the rental property.  But the best way to avoid that issue is to avoid committing tax fraud.

It's remotely possible that you'll get a random 100% audit, too, but it's a lower probability than being struck by lightning while you're surfing as your longboard is attacked by a shark.

[Nate_D]

Good points, Nords. As far as I know, taxes I've filed over the past several years have been on the up and up...I'm not trying to grift anyone here. Clearly the issue of cost basis has been a point of confusion for me...that was part of the reason I hired an accountant to do my taxes for a couple years after I converted the property to a rental (I use TurboTax now). Hopefully I'll be able to continue onward with the initial basis he used without stirring up trouble.