If you have outgrown your current residence or want to move for other reasons, you have a few choices to make, such as selling or renting out your home. If market conditions are favorable, you could sell the property, cashing in your equity and making a profit. If getting your equity out of the property isn’t a must, you may also consider using the house to generate income as a rental property.
This is the first of two articles about converting a principal residence to a residential income property. While we will be exploring some of the main considerations for this type of conversion, the tax code is very complex, and it is advisable to work with a certified public accountant who can offer advice based on your personal situation.
A primary residence is defined as a living space which you inhabit, but may rent out for up to two weeks per year without paying tax on the income. On the other hand, a rental home is primarily used as an income property, and personal use does not exceed the greater of 14 days or 10 percent of the number of days during the year the home is rented. If you are planning on turning your primary residence into a rental property, there are tax considerations to take into account before making a final decision.
Once you make the conversion, taxes on the property will be handled differently. While you will have to report the income from the rental as taxable income, you may also be allowed to deduct expenses for maintaining and fixing the property, as well as take a deduction for depreciation. Should you choose to sell the rental, the basis for calculating taxes on the gain (or loss) for the income property will be different than the calculations for a primary residence.
Tax deductions for landlords. The Internal Revenue Service allows you to claim deductions on your income taxes for depreciation and other write-offs for rental properties. You can use the depreciation to offset the income the house will generate from rent. You can also make allowable deductions on your income taxes, which will offset the rental income you receive from your tenants. Here is a breakdown of possible rental property deductions:
- Mortgage interest
- Property taxes
- Association fees (HOA)
- Repairs and maintenance
In most situations, under the passive activity loss (PAL) rules, you cannot write off deductions that are more than the total sum of the rent received, unless during that year your “adjusted gross income doesn’t exceed $100,000, you actively participate in running the home-rental business, and your losses from all real estate activities in which you actively participate don’t exceed $25,000,” according to the The Savvy Real Estate Investor website. Note that the limits are for individuals using a single tax filing status, and the threshold will vary depending on your personal filing status. Basically, the PAL rules mainly provide exceptions for those that can offset their deduction losses by gains on other properties.
Tax basis for depreciation. There is a formula for computing the tax basis of a personal residence converted to rental property. In general, the adjusted tax basis of a primary residence is the purchase price of the home plus amounts spent for capital improvements that have added value to the property, prolonged its life, or adapted it for a new use. Examples of qualified improvements include additional square footage, fences, or landscape improvements. Note that regular repairs and maintenance are not included in the adjusted tax basis of the home.
When a personal residence is converted to rental property, you need to know the basis for depreciation purposes. This is the lower of your adjusted basis in the residence at the date of conversion (purchase price plus qualified capital improvements), or the fair market value of the property at the time of conversion. In general, you must depreciate your residential rental property over a 27.5-year period. Depreciation, however, only applies to the portion of the house used solely for generating income and does not apply to land. So if you purchase a multi-family and wish to rent one unit and live in another, you can only deduct the depreciation expense on the rented portion.
The IRS provides depreciation tables to assist you in determining the depreciation expense to recognize each year. But be aware that each of the assets may have a separate life. For example, the structure is based on 27.5 years versus appliances, which would be seven years. Consult with your tax advisor to assist you with this calculation.
Selling a converted rental property. When you decide to sell a personal residence, you cannot write off any depreciation expense, as you can with a rental property. In order to calculate the capital gain or loss when you sell a primary residence that had been converted to rental property, you need to know three things: 1) Your adjusted basis in the property (both at the time of conversion and at the time of the sale); 2) The sale price; 3) The fair market value of the property when it was converted to rental property.
If the converted property is sold at a gain, the basis for the purposes of calculating the capital gain is your adjusted tax basis on the property at the time of the sale. However, if the sale results in a loss, the basis is the lower of the property’s adjusted tax basis at the time of the conversion or the fair market value of property when it was converted from personal use to a rental.
Dexter converted his primary residence to a rental property. He originally paid $320,000 for the property, the assessed value of the land was $40,000 and the home was $280,000. When the home was converted to a rental on Jan. 1 it had a fair market value of $360,000, of which $50,000 was land. Fifteen years later, he sells the property for $500,000.
|1. Original cost||$280,000|
|2. FMV at conversion||$310,000|
|3. Depreciation taken||$152,727|
|4. Adjusted basis if sold at gain (#1 – #3)||$127,273|
|5. Adjusted basis if sold at loss (lesser of #1 – #3 or #2 – #3)||$127,273|
|6. Sale price||$500,000|
|7. Capital gain (#6 – #4)||$372,727|
For simplicity, this example excludes the potential impact of carryover losses and depreciation recapture. At a high level, depreciation recapture is essentially paying tax on a portion of the depreciation deductions (discussed earlier). Depreciation recapture tax is assessed at a different rate (25 percent in 2015) and only applies to the lesser of the gain or depreciation already taken. Sound complicated? It is. That’s why it’s important to consult a tax professional.
There are tax benefits for selling a primary residence that won’t be available on a long-term rental property. When selling your converted rental property, you lose the home sale exclusion. In 2015, the first $250,000 for single, or $500,000 of gain for married filing jointly is excluded from taxable income for the sale of a primary personal residence you’ve lived in for at least the last two of five years.
Real estate can be a great investment, particularly if you’re in a stable or developing neighborhood. There are many complicated tax guidelines when it comes to converting a primary residence that should be considered before making the final decision. In my next post, we’ll discuss cash flows, tenant rights and other considerations.