If you're planning to move out of your current home, you face a tough question: Should you sell your home, or would it be more beneficial to convert it into an income-producing rental property? In terms of both selling prices and rental rates, the residential real estate market has cooled off in many areas. Even so, holding on to your property might seem like a solid investment. There are also tax implications to factor into your decision.
If you decide to convert your home into a rental property, you'll be able to claim tax write-offs to offset the income. For example, you can deduct mortgage interest and real estate taxes.
You can also write off all the standard operating expenses that go along with owning a rental property. Examples include utilities, insurance, repairs, maintenance, yard care and homeowners' association fees. In addition, depreciation deductions are a noncash expense that can shelter some or all of your cash flow from federal income tax.
You can depreciate the tax basis of a residential building (not the land) over 27½ years using the straight-line method, while the property may continue to appreciate. Your property's initial tax basis for depreciation purposes usually equals the original purchase price, minus the purchase price allocable to the land, plus the cost of improvements, minus any depreciation write-offs that you've claimed over the years. For example, you might have written off depreciation from a deductible home office.
To illustrate the advantages of claiming depreciation, suppose you decide to convert your home into a rental. The tax basis in the property (excluding the land) is $700,000. Your annual depreciation deduction would be $25,455 ($700,000 divided by 27½ years). That means you can have up to $25,455 of positive cash flow each year from your rental property without having to share with Uncle Sam.
If your rental property throws off a tax loss, things can get complicated. The passive activity loss (PAL) rules will usually apply. In general, the PAL rules allow you to deduct passive rental losses only to the extent you have passive income from other sources. Examples include passive income from other rental properties or gains from selling them. Passive losses in excess of passive income are suspended until you either have some passive income or you sell the property that produced the losses.
As a result, the PAL rules can postpone rental property loss deductions, sometimes for many years. Fortunately, there are exceptions to the rules that may allow you to deduct losses sooner rather than later. (See "3 Taxpayer Friendly Exceptions to the PAL Rules" below.)
Eventually, your rental property should start generating taxable income instead of losses, because escalating rents will surpass your deductible expenses. Of course, you must pay income taxes on those profits. But if you piled up suspended passive losses in earlier years, you can use them to offset your current passive profits.
In addition, passive income from rental real estate can get hit with the 3.8% net investment income tax (NIIT), along with gains from selling a rental property. The NIIT is on top of the regular income tax rate or regular capital gains tax rate. However, the NIIT only affects people with relatively high incomes. You may owe state income tax, too, if applicable.
The expectation is that you'll eventually sell a rental property. If so, you'll have a tax gain to the extent that the net sales price exceeds your tax basis in the property, after adding the cost of any improvements and subtracting depreciation deductions.
If you sell your former principal residence within three years after converting it into a rental, the federal home sale gain exclusion will usually be available. Under that deal, you can shelter up to $250,000 of otherwise-taxable gain (up to $500,000 if you're married). However, you can't shelter gain attributable to depreciation deductions. That part of your gain will be taxed at a 25% federal rate.
The tax results without the home sale gain exclusion are still favorable. For example, say you sell a rental property that you've owned for more than one year, and the gain exclusion isn't available. Here, your taxable gain is the difference between the net sales proceeds and the tax basis of the property after subtracting depreciation deductions. The gain qualifies as a long-term capital gain that's taxed at a federal rate of no more than 20% (23.8% if you owe the NIIT).
Again, the amount of gain equal to the cumulative depreciation deductions claimed for the property will be taxed at a 25% federal rate. You may also owe the 3.8% NIIT and state income tax on that part of the gain. You can use any suspended passive losses to offset your gain from selling the property.
The tax law allows rental real estate owners to effectively sell appreciated property, reinvest the proceeds and defer the federal income hit indefinitely. This strategy is called a Section 1031 like-kind exchange, named for the applicable section of the tax code.
With a Sec. 1031 exchange, you swap the property you want to unload for another property (the replacement property). You're allowed to defer paying taxes until you sell the replacement property. Or when you're ready to unload the replacement property, you can arrange another Sec. 1031 exchange and continue deferring taxes.
The Sec. 1031 exchange rules provide flexibility when selecting replacement properties. For example, you can trade holdings in one area for properties in more-promising locations. You could also swap an expensive single-family rental house for a small apartment building, an interest in a strip shopping center or even raw land.
If you die while still owning the replacement property, current law gives your heirs a federal income tax basis step-up to equal the fair market value of the property as of your date of death — or as of six months later if the executor of your estate chooses. So, your heirs can sell the property and owe little or nothing to Uncle Sam.
Converting a personal residence into a rental property can be a tax-smart move. But it's not right for every situation, and there's more to factor into your decision than just taxes. Consult your tax advisor to determine what's right for you.
If you decide to convert your personal residence into a rental property — whether because you’re moving, seeking rental income or holding the property for long-term investment — you open the door to a different set of tax rules. This guide walks you through what changes, what stays the same and what to watch out for when converting a home to a rental property.
Once your home becomes a rental, all rent received must be reported as income, typically on Schedule E of your federal return. You become eligible to deduct ordinary rental expenses, including mortgage interest, real estate taxes, insurance, utilities, maintenance, HOA fees, repairs and proper upkeep.
You can also claim depreciation on the building, but not the land, under the standard 27.5-year recovery period for residential rental property. These deductions can shelter some or all your rental cash flow from federal income tax, especially if rental income is modest or offset by significant expenses or depreciation.
When you convert your personal home to rental use, tax law treats its basis for depreciation and any future sale differently than for a property always held as rental property. For depreciation purposes, the depreciable tax basis of the building is generally the lower of: 1) the home’s fair market value on the conversion date, or 2) your adjusted basis on that date.
Adjusted basis generally means your original purchase price plus capital improvements, minus any depreciation deductions previously claimed, such as for a deductible home office. If the home’s fair market value has dropped below your adjusted basis by the time of conversion, that lower fair market value generally must be used to calculate depreciation after conversion.
These special basis rules also matter when you eventually sell the property. For purposes of calculating a deductible loss, the basis is generally the lower of the property’s fair market value on the conversion date or its adjusted basis on that date, reduced by depreciation claimed after conversion. As a result, losses attributable to a decline in value before the conversion usually are not deductible.
However, if you later sell the converted property at a gain, a different rule generally applies. Gain is typically calculated using the property’s regular adjusted basis rather than the lower fair market value on the conversion date. Because different basis rules can apply for gain and loss, it’s possible to end up in a middle range where a sale results in neither a taxable gain nor a deductible loss.
If your rental expenses — including mortgage interest, maintenance, depreciation, insurance and other carrying costs — exceed rental income, you may have a net rental loss. However, such losses are generally subject to the passive activity loss rules, meaning you typically can deduct them only against passive income.
If you do not have passive income to offset those losses, they are often suspended until you either generate passive income or sell the property. So while converting a home to a rental property can create valuable deductions, it does not always guarantee immediate current-year tax savings.
Converting to rental use changes or limits certain tax benefits tied to personal residences. The home sale gain exclusion under Internal Revenue Code Section 121 — commonly up to $250,000 of gain for single filers or up to $500,000 for married couples filing jointly — becomes more complicated once rental use begins.
Since depreciation will generally be claimed after conversion, you may face depreciation recapture when the property is sold, which can reduce the benefit of any available Section 121 gain exclusion. For some owners, especially those who later move back into the property, mixing personal and rental use can create additional compliance and tax-planning complexity.
Timing can also matter. If your home has declined in value, converting it sooner rather than later may preserve the possibility of recognizing a deductible post-conversion loss if the property continues to fall in value after the conversion date. Waiting longer may mean more of the decline occurred while the home was still a personal residence, in which case that drop in value generally won’t help you for tax-loss purposes.
On the other hand, if the market rebounds and you later sell at a profit, the gain calculation generally follows the regular adjusted basis rules. That’s one reason why planning the timing of a conversion can make a meaningful difference in the long-term tax result.
Converting a personal residence into a rental property can offer tax advantages, but the rules are more complex than many owners expect. Depreciation, passive loss limitations, basis rules, gain treatment, loss treatment and the timing of a future sale can all affect the outcome. Before making the switch, consult your tax advisor to evaluate the tax implications of converting a home to a rental property based on your specific situation.
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