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Converting Your Home to Rental Property

Taxing Your Home as Rental Property – Gains, Losses, and the Eventual Sale

Lots of folks buy homes with a plan.  They live in them for a time, building equity, using their skills to improve them, and after a few years leverage their gains to buy new homes.  And round they go again, climbing the economic ladder.  But after the 2008 crash making that next sale at a reasonable profit became more difficult.  Many found themselves sitting on non-deductible potential losses just waiting to be realized.

Other folks, whether coming out of divorce with underwater mortgages or just looking to relocate, face a similar dilemma.  And at one time or another just about everyone has the same thought:  Maybe I could rent the home for awhile and sell it later, when the market improves.

It’s a solid enough plan, if you have the energy and stomach for it and there are renters available.  It could make you money over time.  And so, of course, it has tax consequences that need to be considered.

First, converting your personal residence into rental property is really entering into a new kind of investment.  At the date of conversion there is a change in the tax status of the home.  But not to worry:  despite the change, for tax purposes no gain or loss is recognized on the conversion.

Second, you’re going be receiving rental revenue, and incurring expenses for maintenance, insurance, real estate taxes, mortgage interest, and so on.  You’ll also be allowed to take depreciation deductions against the rental revenue equal to the home’s “basis for depreciation” spread evenly over 27.5 years.  Note that the basis for depreciation isn’t necessarily what you paid for the home.  It’s whichever is smaller on the date of conversion: your basis in the home (typically what you paid for it) and its fair market value.[1]

For many, all these deductions mean they will wind up with a net loss on the year.  That loss (or gain, if it works out that way) will move straight onto form 1040 and reduce (or increase) your other taxable income.

More good news:  You’ll report your earnings on schedule E instead of Schedule C (the one for small business income).  This is a big difference because, unless you cross the line to “real estate professional”, rental income is passive income and so not subject to self-employment taxes (which for 2013 total 15.3% for both social security and Medicare).

Finally, the time may come when you’re ready and able to sell the home.  At that point you’ll pay capital gains tax (or take a capital loss) on the difference between the selling price (less any seller’s settlement costs) and your adjusted basis.[2]  The adjusted basis is what you paid for the home less all those sweet depreciation deductions you took.  Notice that while they reduced your ordinary income during the rental period they will increase you gain on the sale.  Lucky for you, capital gains are taxed at a lower rate than earned income.

Note:  Watch out for recapture income.  If you sell the house for more than your adjusted basis then you have to recognize – as regular income, not capital gains – that extra amount.  Depreciation is a good thing, tax-wise, but that doesn’t mean it doesn’t have a downside.

The moral here is that while converting a personal residence to rental property can have real benefits it’s not without risks, both operationally and come tax time.  Before you take the plunge make sure you’re ready to face them all.


 

[1] Note that even if you choose not to take the depreciation deductions, when you sell the home your basis will be written down as though you had taken them.

[2] The gain won’t be eligible for exclusion from income because the home is no longer your personal residence.


This article is for informational purposes only and does not constitute legal advice.  You should consult a qualified attorney before taking any action.