Converting primary residence to rental to second home - tax implications

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DrTravel

Active member
Been doing some research on this and am still confused - so figured the TI forum experts would be the most reliable source!

The scenario - couple buys a home in 2000, lives in it to 2011 then buys another home and rents out the first one. Now the couple's kid is going to get married and needs a place to live but can't afford to buy their own place. Mom & dad have this extra house lying around so think their kid should live in it and pay all the expenses involved as rent (mortgage, property tax HOA etc.). So now there are two options: keep the property as a rental and keep deducting all expenses as before - or - "convert" the property to a second home, have the kids make all the payments direct and don't file Schedule E anymore and you stop taking depreciation. Under the first option Schedule E would show a loss plus you get to deduct depreciation - the kids "rent" would actually be 25% lower than that from the current renters. Under the second option, the kids payment wouldn't exceed the standard deduction.

Now when the first property is sold, calculating the basis becomes a little tricky under the second option. However upon the death of the couple, the house (which is in a trust) would revert to the kid and the tax basis would be adjusted to the current market value, but then there is that little depreciation to recapture. I'm not sure if the IRS would ignore all that depreciation so I think the new basis would be the current market value less the depreciation already taken. Not sure about this. So I'm guessing that if the first home is treated as rental the couple could still get the tax advantage of depreciation, however the kids would essentially be recapturing it when they eventually sell. Then again if you the first home is now treated as a second home, that wouldn't be the case. And of course, there really isn't any guarantee that the house will not be sold by the couple prior to their passing because life happens!

So...what would you do? Not sure what the couple's best course of action would be.

 
DrTravel said:
Been doing some research on this and am still confused - so figured the TI forum experts would be the most reliable source!

The scenario - couple buys a home in 2000, lives in it to 2011 then buys another home and rents out the first one. Now the couple's kid is going to get married and needs a place to live but can't afford to buy their own place. Mom & dad have this extra house lying around so think their kid should live in it and pay all the expenses involved as rent (mortgage, property tax HOA etc.). So now there are two options: keep the property as a rental and keep deducting all expenses as before - or - "convert" the property to a second home, have the kids make all the payments direct and don't file Schedule E anymore and you stop taking depreciation. Under the first option Schedule E would show a loss plus you get to deduct depreciation - the kids "rent" would actually be 25% lower than that from the current renters. Under the second option, the kids payment wouldn't exceed the standard deduction.

Now when the first property is sold, calculating the basis becomes a little tricky under the second option. However upon the death of the couple, the house (which is in a trust) would revert to the kid and the tax basis would be adjusted to the current market value, but then there is that little depreciation to recapture. I'm not sure if the IRS would ignore all that depreciation so I think the new basis would be the current market value less the depreciation already taken. Not sure about this. So I'm guessing that if the first home is treated as rental the couple could still get the tax advantage of depreciation, however the kids would essentially be recapturing it when they eventually sell. Then again if you the first home is now treated as a second home, that wouldn't be the case. And of course, there really isn't any guarantee that the house will not be sold by the couple prior to their passing because life happens!

So...what would you do? Not sure what the couple's best course of action would be.
Click to expand...

This is a tricky situation. If the couple had the home as a rental property on their Schedule E then not "converting" the home to a second home and stop reporting it as a rental property on the tax return would be a red flag.  Also, the IRS will look at the current "market" rental rate especially if it is a non-arm's length lease with you would have with a family member which is below the "market" rental rate. 

Here's another option, the kids that are moving into the home can claim the interest and property tax (subject to the SALT limitation) and claim it as their primary residence.  The rules to do so are basically 2 things for the kids to take deductions on the home....occupancy test (living in the home) and means test (showing that they are making the payments even if the 1098 goes to the parents). 
 
USCTrojanCPA said:
This is a tricky situation. If the couple had the home as a rental property on their Schedule E then not "converting" the home to a second home and stop reporting it as a rental property on the tax return would be a red flag.  Also, the IRS will look at the current "market" rental rate especially if it is a non-arm's length lease with you would have with a family member which is below the "market" rental rate. 

Here's another option, the kids that are moving into the home can claim the interest and property tax (subject to the SALT limitation) and claim it as their primary residence.  The rules to do so are basically 2 things for the kids to take deductions on the home....occupancy test (living in the home) and means test (showing that they are making the payments even if the 1098 goes to the parents).
Click to expand...

I know it's tricky that's why I'm scared to offer an opinion! Sounds like if they continue to claim it as rental property, they had better use market value rent on Schedule E (even if they don't actually collect that much). You seem to indicate that by not calling it rental property, i.e. second home, that the IRS computers will say what happened when Schedule E is no longer part of the their tax return. But then again if the kids live in the house and make the payments their itemized deductions for taxes and interest would not exceed the $24K standard deduction so even their returns would not show these deductions. I guess in case of an audit the kids could show proof of payment to the IRS.

I'm wondering what do people do if they have a second vacation home which they rent out but then decide to not do that anymore and just let their family and friends use the property.
 
DrTravel said:
USCTrojanCPA said:
This is a tricky situation. If the couple had the home as a rental property on their Schedule E then not "converting" the home to a second home and stop reporting it as a rental property on the tax return would be a red flag.  Also, the IRS will look at the current "market" rental rate especially if it is a non-arm's length lease with you would have with a family member which is below the "market" rental rate. 

Here's another option, the kids that are moving into the home can claim the interest and property tax (subject to the SALT limitation) and claim it as their primary residence.  The rules to do so are basically 2 things for the kids to take deductions on the home....occupancy test (living in the home) and means test (showing that they are making the payments even if the 1098 goes to the parents).
Click to expand...

I know it's tricky that's why I'm scared to offer an opinion! Sounds like if they continue to claim it as rental property, they had better use market value rent on Schedule E (even if they don't actually collect that much). You seem to indicate that by not calling it rental property, i.e. second home, that the IRS computers will say what happened when Schedule E is no longer part of the their tax return. But then again if the kids live in the house and make the payments their itemized deductions for taxes and interest would not exceed the $24K standard deduction so even their returns would not show these deductions. I guess in case of an audit the kids could show proof of payment to the IRS.

I'm wondering what do people do if they have a second vacation home which they rent out but then decide to not do that anymore and just let their family and friends use the property.
Click to expand...

It's just a red flag for the IRS when you start converting properties from a second home to a rental and vice versa, doesn't mean that you'll get audited.  If the home is rented out, it has to be rented at the higher of market or actual for IRS purposes.  I think the options are to keep it as a rental property and continue reporting a "low" market rental rate OR have the kids claim the deductions (interest and property tax as if it's their primary residence).  It's best to run the numbers to see which scenario makes the most financial sense. 
 
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