Abstract: In
some cases, homeowners move to new residences, but keep their present homes and
rent them out. Homeowners who are considering this are probably already aware
of the financial risks and rewards of doing so. However, they should also know
that renting out a personal residence carries potential tax benefits and
pitfalls.
Thinking about converting
your home into a rental property?
In some cases, homeowners move to new
residences, but keep their present homes and rent them out. If you’re thinking
of doing this, you’re probably aware of the financial risks and rewards.
However, you also should know that renting out your home carries potential tax
benefits and pitfalls.
You’re generally treated as a regular real
estate landlord once you begin renting your home. That means you must report
rental income on your tax return, but you’re also entitled to offsetting
deductions for the money you spend on utilities, operating expenses, incidental
repairs and maintenance (for example, fixing a leak in the roof). Additionally,
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 not be able to currently deduct the rent-related deductions that
exceed your rental income unless an exception applies. Under the most widely
applicable exception, the PAL rules won’t affect your converted property 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.
You should also be aware that potential tax
pitfalls may arise from renting your residence. Unless your rentals are
strictly temporary and are made necessary by adverse market conditions, you
could forfeit an important tax break for home sellers if you finally sell the
home at a profit. 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. So, renting your home out for an extended time could
jeopardize a big tax break.
What if you don’t rent out your home long
enough to jeopardize your principal residence exclusion? The tax break you
would have gotten 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. However, if you’re in this situation, be aware that you may
not wind up with much of a loss for tax purposes. That's because the beginning basis
(the cost for tax purposes) when the home is first converted to a rental
property is equal to the lesser of actual cost or the property’s fair market
value when it’s converted to rental property. So, 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.
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