While there are many details to be aware of when converting your home into a rental – tax issues should be considered first. There are many reasons to convert a home into a rental. For example, having a prior home produce income and appreciation after the owner buys a new home. Or to help maximize the tax benefits for an elderly person who can no longer live alone by delaying the sale of that person’s home. All valid reasons to convert a home into a rental. Some homeowners even (mistakenly) think that, when a home has declined in value, converting it into a rental can allow them to deduct that loss. Regardless of why an individual considers converting a home into a rental, a number of tax issues can come into play.
Lingo and Definitions You Need to Know When Converting a Home into a Rental
Basis
The basis of the converted property is a good starting point for examining these conversion-related tax issues. A basis is the starting value that is used to calculate gains or losses for tax purposes. The basis is also used to determine the amount of depreciation that can be claimed. Generally, for depreciation purposes, a property’s depreciable basis on the date of the conversion is the lower of its adjusted basis (the original cost, plus the value of any improvements, minus the deducted casualty losses) or its fair market value (FMV).
Example #1
A home’s original purchase cost was $250,000; the homeowner later added a room at a cost of $50,000. At the time of the conversion, there are no casualty losses, so the home’s adjusted basis is $300,000 ($250,000 + $50,000). By comparison, the property’s FMV is $350,000, so the depreciable basis for the rental is the lower of the two amounts: $300,000.
Example #2
If, on the date of the conversion, a home has the same adjusted basis as in Example #1, but its FMV is only $225,000, then the depreciable basis used for the rental is equal to $225,000, as that is the lower of the two amounts.
When a home’s FMV is less than its adjusted basis on the date of conversion, as in Example #2, the rental has dual bases:
If the rental is then sold for a loss, the basis for loss is the FMV on the date of the home’s conversion. Because losses from the sale of personal-use properties (such as homes) are not deductible, this rule prevents homeowners whose homes have declined in value from converting them into rentals in order to claim tax losses.
If the rental home is then sold for a profit, the basis for the gain is considered the property’s adjusted basis.
Depreciation
Depreciation is an allowance that both accounts for wear and tear. It also provides a systematic way for the owner to recover the initial investment in the property. Currently, the tax law doesn’t allow homeowners to deduce the entire cost of a residential rental at one time. Despite this statutory allowance for the depreciation of residential rentals, real properties have historically appreciated rather than depreciated. So this allowance typically provides a significant tax advantage (i.e., a write-off).
Here is how to determine the depreciation for a residential rental. First, reduce the basis by the value of the surrounding land to get the value of the improvements. Second, multiply that value by .03636 (the depreciation rate). Generally, the value of the land is based on a property-tax statement.
Example
When a property is valued at $240,000 and the land is valued at $80,000, then 1/3 of the basis is allocated to land, and the remaining 2/3 of the basis is allocated to improvements. Thus, if the basis is $300,000, then the depreciable improvements are valued at $200,000 (2/3 × $300,000). And the annual depreciation deduction is $7,272 (.03636 × $200,000).
Turning Your Home into a Rental? Consider Rental Cash Flow versus Taxable Profit or Loss
Cash flow is the net amount after subtracting expenses from rental income. Taxable profit or loss is the rental income minus any allowable tax deductions. Of course, higher cash flow is always better. However it is particularly important to avoid having a rental with a negative cash flow. The following example compares cash flow to taxable income.
COMPARISON OF CASH FLOW AND TAXABLE INCOME
Income/Expense
Cash Flow ($)
Taxable Income ($)
Rental Income
30,000
30,000
Mortgage Payment
<23,000>
Mortgage Interest
<20,700>
Real Property Tax
<2,400>
<2,400>
Insurance
<1,800>
<1,800>
Maintenance & Repairs
<400>
<400>
Gardening
<800>
<800>
Depreciation
<7,272>
Total Expenses
<28,400>
<33,372>
Cash Flow
1,600
Taxable Income
<3,372>
There is a major difference between cash flow and taxable income. Cash flow includes the deduction for the entire mortgage payment, (not just the interest). However it does not include the deduction for depreciation. In the above example, the rental has $1,600 in positive cash flow for the year. But also has a passive loss (tax write-off) of $3,372.
Passive Losses
Losses from residential rental real estate are classified as passive and can only offset passive income. While deductions are limited to $25,000 p/y from passive losses for most taxpayers. (Taxpayers with adjusted gross incomes (AGIs) of $100,000 or less). This limit is phased out for AGIs up to $150,000. Thus, taxpayers’ ability to benefit from a tax write-off on a rental is dependent upon their AGIs. The good news is that the passive losses in excess of this limit carry over to future years. And losses can be used to offset other passive income in those future years. In addition, once the rental is sold, any unused carryforward amount and passive losses in the sale year are deductible in full.
Home Gain Exclusion when Converting a Home into a Rental
IRC Section 121 allows homeowners to exclude up to $250,000 of gains from a home sale if they owned and used that home (as their primary residence) for at least 2 of the 5 years prior to the sale date. For married couples filing jointly the excluded amount jumps to $500,000. Provided that both have used the property as a primary residence for 2 out of the prior 5 years. AND provided that at least one has owned the property for 2 out of the prior 5 years. This is a very important consideration! As once a home is converted into a rental, the homeowner loses the ability to exclude gains after 3 years. (Because at that point, it is no longer possible to meet the 2-out-of-5-years qualifications).
Even when a homeowner sells a rental property after its conversion but before the exclusion expires, any depreciation that was claimed during the rental period must be recaptured as taxable income.
As shown above, there are many important tax issues related to converting a home into a rental. Even aside from the problems related to acting as a landlord. Please call this office if you need assistance with these tax issues. Or if you would like help deciding whether to convert a home into a rental.
Watch Out For Those Fake IRS Letters
