Conversion of Personal Real Estate to Rental Property?
April 28th, 2010 | 
Author: If a house’s Fair Market Value is less than mortgage due, and the taxpayer wants to convert the property to rental property, what are the tax implications of converting?
The property begins as the principal residence, but if converted will no longer be residence.
Posted in Rental Properties
If the debt on the property is acquisition debt, meaning it was incurred to buy, build, or improve the property, then the interest on the debt is fully deductible as a rental expense. If there is nonacquisition debt on the property, that interest is not deductible as a rental expense. Even though some or all of that interest may have been deductible on a principal residence, it will be disallowed as a business deduction. This is true whether or not the debt on the property is more than the FMV of the property.
You will depreciate the property according to the lesser of its basis or its FMV on the date of the conversion. This is unrelated to the amount of debt on the property.
The principal issue when converting from personal residence to rental is your basis in the property for depreciation purposes. The amount of the outstanding mortgage is irrelevant. You must depreciate rental property since the depreciation is subject to recapture at sale time even if you don’t take it while you hold the property for rental.
To determine the basis you need several pieces of data:
1. Your original basis in the property.
2. The dollar amount of any improvements made while you occupied it as your residence.
3. The fair market value of the property when you converted it to rental use.
4. The value of the land both when you bought the property and when you converted it to rental use.
For items 1 and 2 your records will suffice. Items 3 and 4 should be backed up with professional appraisals by a licensed real estate appraiser to avoid any hassles with the IRS down the road. The IRS may not question your depreciation deductions year in and year out but they can still challenge what should have been *allowable* depreciation 20 years down the road when you sell. Having weak proof of your position at that time could be catastrophically expensive for you! “Point in Time” appraisals are always risky and the older the point in time, the hazier they get.
Your basis for depreciation once you convert it is the lower of the adjusted basis (items 1 and 2) or the fair market value when you converted it to rental use. You then deduct the lesser land value (at purchase time or conversion time) from this figure to get the basis for depreciating it as a rental since you cannot depreciate land.
Once you have your depreciable value you depreciate it on a straight-line basis for a 27.5 year term.
Going forward you offset your rental income with rental expenses including mortgage interest, depreciation, property taxes, repairs and maintenance, utilities, rental agent commissions, property management fees, etc.
Note that mortgage interest is limited to the mortgage that you took out to buy the property or make improvements to it. If you have any mortgage debt that was used to cash out equity for other purposes you cannot use that against rental income (but may be able to use it on Schedule A).
Deleting answer.
Poster is now asking so many questions this is clearly homework.