Imagine that a married couple buys a house on January 1st 2001 for
500K and lives in it for 5 years. On January 1st 2006 they rent out
the house. The market value of the house is 700K at that point. The
house is rented out for several years and on January 1st 2011 the
couple sells the house for 900K.
Is the capital gain 900K - 500K or 900K - 700K (the house value at the
time it stopped to be their primary residence)?
I am not looking at precise calculations - just trying to understand
if the calculations goes back all the way to the initial purchase
price or just back to when they converted it to a rental property.
The answer is not so simple.
On January 1st 2006, the homeowners put the property in service as a rental. At that time they set the basis of the property. They then each year depreciated the property when they figured their income tax each year.
Of course when they calculated the value for depreciation, that is the house only, not the land.
from IRS Pub 527 Residential Rental Property
Separating cost of land and buildings.
If you buy buildings and your cost includes the cost of the land on
which they stand, you must divide the cost between the land and the
buildings to figure the basis for depreciation of the buildings. The
part of the cost that you allocate to each asset is the ratio of the
fair market value of that asset to the fair market value of the whole
property at the time you buy it.
If you aren’t certain of the fair market values of the land and the
buildings, you can divide the cost between them based on their
assessed values for real estate tax purposes.
You buy a house and land for $200,000. The purchase contract doesn’t
specify how much of the purchase price is for the house and how much
is for the land. The latest real estate tax assessment on the property
was based on an assessed value of $160,000, of which $136,000 was for
the house and $24,000 was for the land. You can allocate 85% ($136,000
÷ $160,000) of the purchase price to the house and 15% ($24,000 ÷
$160,000) of the purchase price to the land. Your basis in the house
is $170,000 (85% of $200,000) and your basis in the land is $30,000
(15% of $200,000).
Of course there is the complication that the house was not a rental for the first 5 years of ownership.
also from IRS Pub 527:
Basis of Property Changed to Rental Use
When you change property you held for personal use to rental use (for
example, you rent your former home), the basis for depreciation will
be the lesser of the fair market value or adjusted basis on the date
Fair market value.
This is the price at which the property would change hands between a
willing buyer and a willing seller, neither having to buy or sell, and
both having reasonable knowledge of all the relevant facts. Sales of
similar property, on or about the same date, may be helpful in
figuring the fair market value of the property.
Figuring the basis.
The basis for depreciation is the lesser of:
The fair market value of the property on the date you changed it to rental use; or
Your adjusted basis on the date of the change—that is, your original cost or other basis of the property, plus the cost of
permanent additions or improvements since you acquired it, minus
deductions for any casualty or theft losses claimed on earlier years'
income tax returns and other decreases to basis. For other increases
and decreases to basis, see Adjusted Basis in chapter 2.
You originally built a house for $140,000 on a lot that cost you
$14,000, which you used as your home for many years. Before changing
the property to rental use this year, you added $28,000 of permanent
improvements to the house and claimed a $3,500 casualty loss deduction
for damage to the house. Part of the improvements qualified for a $500
residential energy credit, which you claimed on a prior year tax
return. Because land isn’t depreciable, you can only include the cost
of the house when figuring the basis for depreciation.
The adjusted basis of the house at the time of the change in its use
was $164,000 ($140,000 + $28,000 − $3,500 − $500).
On the date of the change in use, your property had a fair market
value of $168,000, of which $21,000 was for the land and $147,000 was
for the house.
The basis for depreciation on the house is the fair market value on
the date of the change ($147,000) because it is less than your
adjusted basis ($164,000).
Which then brings you to the fun calculation when the house is sold, and the IRS wants to recapture the depreciation.
So knowing that the house entire property was worth $700K isn't enough. There will have to be a split of the value between house and land at the time of purchase and the time it became a rental property. Then the house is depreciated for 5 years. All this assumes that there were no other events that changed the basis, or have to be depreciated on their own.
Note: Pub 527 has changed along with tax law, so it is possible that items in the publication don't apply to the question because of recent tax law changes.