165 Losses

Internal Revenue Code § 165 - Losses

The U.S. tax consequences on sales of mixed residential property - Loss deductions on property that is split between personal use and business/trade/"for profit" use.

While taxpayers are normally not allowed to deduct losses related to personal-use property, they can deduct them when losses are incurred on property that is used in a trade or business or when losses are incurred in any transaction entered into for profit, though not connected with a trade or business. When a taxpayer holds property that is kept for personal use and then converts that property into business/trade property, then the tax consequences are a bit different. Thus, when a taxpayer converts property from one to the other and then disposes (sells) that property, the tax consequences are complicated because only a portion of the loss will be deductible under § 165.

Income Tax Regulations § 1.165-9(b)(1) allows the deduction if the property is first held for personal use and then converted into a rental property or otherwise appropriated to income-producing purposes, it is aloud.

The calculation of the actual loss to be taken into account can be demonstrated very basically as follows:

Taxpayer buys property for $100,000 in year one. Taxpayer lives in house for four years before deciding to rent the property out. At the time of the decision to rent, the property is worth $80,000. The property is rented for 4 years before the owner decides to sell. Taxpayer sells the property for $70,000.
Under Reg. § 1.167(g)-1, the basis in the property at the time of conversion to rental property is the lesser of the original cost of the building ($100,000) or the fair market value at the time of conversion ($80,000). In this case that is clearly $80,000 (as it should often be, because we are talking about property that is decreasing in value.) Once the property is converted to rental property, it can be depreciated under § 167 because it is property held for the production of income. Assuming that the depreciation allowed on the property after conversion to rental property is $4,000 for the four years ($1000 per year), the new basis in the property is $80,000 less the $4000 it depreciated, bringing the adjusted basis to $76,000.
Therefore, the loss allowed under § 165 is $6000 ($76,000 adjusted basis less $70,000 sale price).

However, when the property is treated in reverse order, the answer is not as easy. Assuming all the fact from above, except that the property starts out as rental property and is then converted into personal-use property, the Regulations do not address this issue. Therefore, the result is different. The possible losses allowed are:

1) $0. Because the property was personal at the time it was sold, and the loss deduction allowed under § 165. But this seems like an incorrect answer given that the property was “entered into for profit.” Not to mention it would eliminate Congress' intent to allow losses in transactions that implicate trade/business or for-profit motives.

2) $26,000. Because the basis in the house ($100,000 less the $4000 depreciation) is $96,000, and the property is sold for $70,000, there is a loss of $26,000. This is the most aggressive approach, as it is the maximum amount deductible without any guidance from the Regs. This also seems a little unfair because the taxpayer should not be able to take advantage of claiming losses incurred on personal-use property (even if it was only personal-use property for a limited time).

3) $16,000. It was worth $80,000 at the time it was converted to personal property, and the basis in the property was still $100,000, which produces a $20,000 loss. However, the taxpayer already received the $4000 in depreciation, making the actual loss $16,000. This is essentially the middle ground, and the result that is suggested by the methodology under Reg. § 1.165-9(b)(1), even though the precise situation is not actually addressed in that regulation.

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