Due to the weak real estate market, many homeowners are forced to sell at a loss, if they are able to sell at all. But does this dark financial cloud have a silver lining? Can a homeowner deduct a loss from income taxes?

Unfortunately, the answer to that question is no, as a loss incurred on the sale of a personal asset such as a personal residence is not deductible.

But there is a way to deduct a loss on the sale of a home: You can convert it to a rental before you sell.

This requires you to rent out the home to someone who is not related to you for a reasonable market rent. Moreover, you’ll have to report the rental income you receive to the Internal Revenue Service — but you may have little or no taxable rental profits due to depreciation and other deductions for rental expenses.

When you convert your residence into a rental, you convert it from a personal asset to an investment asset. Losses on the sale of investment assets are tax-deductible.

However, when you convert a residence into a rental home you will not be able to deduct its entire decline in value since you purchased the home.

Rather, your deductible loss upon the home’s later sale is limited to the decline in value after the conversion to a rental. The reason for this is the way in which the home’s adjusted tax basis (value for tax purposes) is calculated.

When you change property you held for personal use to rental use, your adjusted basis is the lesser of the following values:

  • The property’s fair market value at the time of the conversion; or
  • Its adjusted basis at the time of the conversion.

Your adjusted basis is generally the cost of the property plus improvements you had done after the purchase. Fair market value is the price at which the property would change hands between a buyer and a seller, neither having to buy or sell, and both having reasonable knowledge of all the relevant facts.

Example: Jack purchased a home for $400,000 in 2005. In 2009, he decides to rent out the home. Due to the decline in the real estate market, its fair market value at the time of the conversion to a rental is $350,000.

Jack’s adjusted basis in the home, therefore, is $350,000 since this is less than its original $400,000 basis. In 2011, Jack sells the home for $325,000. This leaves him with a $25,000 tax-deductible loss (a $325,000 sales price minus the $350,000 adjusted basis equals a $25,000 loss).

Any homeowner who is seriously thinking about converting his or her home to a rental should obtain an appraisal of its value from a qualified real estate appraiser. This will establish its fair market value at the time of the conversion.

Stephen Fishman is a tax expert, attorney and author who has published 18 books, including "Working for Yourself: Law & Taxes for Contractors, Freelancers and Consultants," "Deduct It," "Working as an Independent Contractor," and "Working with Independent Contractors." He welcomes your questions for this weekly column.

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