Ready to buy your dream home but can’t quite part with your starter home? Converting your personal residence into a rental rather than selling it may have crossed your mind. For some, this makes sense.
Typically, homeowners convert their primary residence into a rental for one of two reasons. If the housing market is down, you can hold off on selling the property, rent it out to pay the mortgage and then sell it when values rise. Others see it as an investment opportunity and a chance to increase cash flow. In some cases, the rental property may be a better return on investment than the stock market.
Regardless of your reasons, it’s important to understand the tax implications of converting your personal residence into a rental. Here are a few to consider.
Tax deductions as a rental
When you convert your home to a rental, you are allowed several deductions that are otherwise disallowed as a personal residence. For example, repairs and maintenance expenses are not deductible for a personal residence but are deductible for a rental. For planning purposes, significant repairs could be postponed until the house becomes a rental, allowing for the deduction of those expenses. Common expenses include:
• Association dues
• Cleaning and maintenance
• Insurance premiums
• Legal and accounting fees
• Management fees
• Mortgage interest
• Pest control and lawn care
• Property taxes
• Tenant credit checks
• Utilities basis for your rental property
Once you turn your primary residence into a rental, you need to know your basis for depreciation purposes. Depreciation will likely provide you with the greatest deduction against your rental income. Your basis for depreciation is the lower of your home’s fair market value at date of conversion or its purchase price plus the cost of improvements. Land does not qualify for depreciation, so you’ll have to back out its value before calculating depreciation.
Residential rentals can be depreciated over 27.5 years. As an example, let’s assume your home’s FMV of $240,000 is less than its cost and the land portion is worth $40,000. Your basis for depreciation is $200,000 ($240,000 minus $40,000). Your depreciation deduction is $7,272 ($200,000 divided by 27.5 years).
Beware of passive losses
If you operate a rental and your expenses exceed income, you may not be able to immediately deduct your loss. Here’s the issue: Rental losses are “passive losses” and can only offset sources of passive income. Without passive income, your losses are suspended until you have passive income in later years or sell the property to an unrelated party. Know that it may be a while before you can deduct your losses.
There are two exceptions. If your adjusted gross income is $100,000 or less, you can deduct rental losses up to $25,000 if you actively participate in the rental. The other exception applies to real estate professionals, who are completely exempt from the rules.
Sheltering gain on sale
The tax benefits of selling your personal residence at a gain disappear when renting long term. Married couples can exclude up to $500,000 of capital gains on the sale of their primary residence. Unmarried taxpayers can exclude up to $250,000. This tax break is available if you owned the property as your principal residence for at least two of the last five years. Once you’ve rented the property for more than three years, you lose your gain exclusion.
The bottom line
Converting your principal residence to a rental can yield many benefits, but it’s important to understand the ramifications of your decision. Consult with a tax adviser to determine what’s best for your situation.
Chris Thornburgh is a CPA and partner at Brown Armstrong Accountancy Corp. Contact her at firstname.lastname@example.org or 324-4971.