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1. There is no direct reporting of the transition - you simply reflect the house on Schedule E (and Form 4562) beginning with the date that it was placed "in service" for rental.
2. Improvements that are made after converting the property to rental status will increase your basis. Improvements made before that will be a part of the initial basis determination (see item 3). So your best bet would be to convert it to rental status before the additional improvements are made.
3. The initial basis will be its cost or FMV at the time of conversion whichever is lower. FMV is subject to interpretation as evidenced by your two appraisals. There is nothing that requires you to accept the lower appraisal. Unless you feel like there was an issue with the higher appraisal that makes it untrustworthy, I would use that one.
4. The determination of basis in 3 only applies to the basis for purposes of depreciation and in the event that you sell it while it is a rental property. In the event that you "re-convert" it to personal use, your basis reverts to your actual cost (less depreciation taken).
Thanks for the complete and quick answer. A couple of follow ups using the original information and your answer as background.
5) When we convert the old home to rental property I understand we will use the market price ($550,000 per appriasal) as basis since that is lower than cos ($610,000 = purchase plus improvements) for the basis. What happens, if we sell it while still in use as a rental to the orginal cost basis? Seems like I lose out on the higher cost basis it currently has?
6) We do not expect the rental income to cover the cost (morg interest, etc) for at least 5 years - and thus will report a carryforward loss. So in that situation is it still more advantageous to do the improvements after the property is converted to rental income since the additional depreciation will only go toward the carry forward loss and will not at least for a long time result in a lower tax position. The unerlieing question here relates to 5 above which is if we are able to recoup the cost basis upon sale (rather than depreciate the improvement that might be more advantagous.
5. If you sell for more than $610k, you will use the $610k as your basis. If you sell between $550k and $610k, your gain will be $0 except to the extent of deprecation. If you sell for less than $550k while it is held as a rental property, you will have a loss based on the $550k basis. In other words, the actual cost prevents you from having a taxable gain but cannot be used to create a deductible loss.
6. The carryforward loss will be fully deductible when the property is disposed of - so that you would still want to do improvements after conversion to rental property. Also, improvements made after conversion add to post conversion basis and are not swallowed up by the appraisal amount.