Thinking About Converting Your Home Into a Rental Property?

In some cases, homeowners move to new residences, but keep their present homes to rent. If you are considering this, be aware of the financial risks and rewards in addition to tax benefits and pitfalls.

You’re generally treated as a regular real estate landlord once you begin renting your home:

• You must report rental income on your tax return,
• You’re also entitled to offsetting deductions for the amounts spent on utilities, operating expenses, incidental repairs and maintenance (for example, fixing a leak in the roof), and
• You can claim depreciation deductions for the home.

You may be able to fully offset rental income with otherwise allowable landlord deductions.

Passive activity rules

However, under the passive activity loss (PAL) rules, you may be limited in currently deducting the rent-related deductions which exceed your rental income unless an exception applies. Under the most widely applicable exception, the PAL rules won’t limit the deductions for a tax year in which:

• Your adjusted gross income doesn’t exceed $100,000,
• You actively participate in running the home-rental business, and
• Your losses from all rental real estate activities in which you actively participate don’t exceed $25,000.

Any deferred losses are available in future years.

Sale of former residence

In general, you can escape tax on up to $250,000 ($500,000 for married couples filing jointly) of gain on the sale of your principal home. However, this tax-free treatment is conditioned on your having used the residence as your principal residence for at least two of the five years preceding the sale. Renting your home out for an extended time could jeopardize a big tax breakunless your rentals are strictly temporary and are made necessary by adverse market conditions.

If you don’t rent out your home long enough to jeopardize your principal residence exclusion, the tax break on the sale (the $250,000/$500,000 exclusion) won’t apply to the extent of any depreciation allowable with respect to the rental or business use of the home for periods after May 6, 1997. It also won’t apply to any gain allocable to a period of nonqualified use (any period during which the property isn’t used as the principal residence for you, your spouse or former spouse) after December 31, 2008. A maximum tax rate of 25% will apply to this gain (attributable to recapture of depreciation deductions).

Selling at a loss

Some homeowners who bought at the height of the market may ultimately sell at a loss. In such situations, the loss is available for tax purposes only if the owner can establish that the home was in fact converted permanently into income-producing property. Here, a longer lease period helps an owner. If you’re in this situation, be aware of the rules determining the loss for tax purposes. When the home is first converted to a rental property the tax basis is established to be the lesser of actual cost or the property’s fair market value when converted. If a home was bought for $300,000, converted to a rental when it was worth $250,000, and ultimately sold for $225,000, the loss would be only $25,000. Keep in mind that depreciation deductions while it was a rental property also reduce basis.

This is a complex decision. Contact us for help reviewing your situation.

The HoganTaylor Tax Practice

If you have any questions about the content of this publication, or if you would like more information about HoganTaylor's Tax practice, please email Tony Otto, Tax Practice Lead, at jotto@hogantaylor.com.

INFORMATIONAL PURPOSE ONLY. This content is for informational purposes only. This content does not constitute professional advice and should not be relied upon by you or any third party, including to operate or promote your business, secure financing or capital in any form, obtain any regulatory or governmental approvals, or otherwise be used in connection with procuring services or other benefits from any entity. Before making any decision or taking any action, you should consult with professional advisors.