In today’s housing market, many homeowners are finding it hard to sell their home without giving it away. One way to weather the housing market we are in is to rent out your present home until the market improves. If you are thinking of doing this, you need to consider not only the economic risks and rewards but the potential tax benefits and pitfalls that could come along with converting your home into a rental property. A brief consultation with a CPA could help you take advantage of the tax benefits and stay away from any pitfalls.
Once you have put your home up for rent, you then start to treat the home as any other rental property. This means that you then start reporting rental income and rental expenses associated with renting the home. The types of rental expenses that you are entitled to deduct are depreciation, insurance, interest, taxes, utilities, any operating expenses, and repairs and maintenance. In a lot of cases, the rental expenses offset the rental income and therefore the rental property produces a loss on the individuals personal tax return. In the year of the rental loss, these losses can be fully deductible, partially deductible, or suspended due to the passive activity loss rules (PAL), the taxpayers adjusted gross income, or the amount of real estate involvement that the taxpayer has.
A personal residence typically has a gain exclusion of $250,000 ($500,000 for married filing joint) if the taxpayer can show that in a 5 year look-back period preceding the sale of the home, the taxpayer had the home as their personal residence for at least 2 of the 5 years. Here is where some proper planning can come into play. If a taxpayer rents their home out for 2 years after they have converted into a rental, they should get with a CPA and a real estate agent in that 3rd year to discuss the tax implications of continuing the home as a rental or selling it. Here is why, if they decide to keep it rented out past the 3 year mark following the conversion, they will then get beyond the look back period. Let’s just say in that time frame the residence between depreciation reducing the cost basis of the property and home values starting to go up the taxpayer now has a gain on the sale of the property. Due to the fact of being outside the window of it being 2 out of 5 years being personal residence, that gain from the sale is now fully taxable. Let’s say the taxpayer sells the home in year 3 of the rental and has the gain. The gain now is not fully taxable and the only amount the taxpayer would have to pick up would be the recapture of any depreciation that was taken over the 3 years of the rental. So renting your home out after conversion from personal residence for an extended time could jeopardize your principle residence exclusion. However, as with many homeowners who bought at the peak of the real estate market it may be beneficial to hold off and show that the home was converted permanently into income-producing property to sell and capture the loss from the sale of the property. Just as the gain is excluded in the 2 of 5 year look-back period, any losses from the sale inside that period are excluded. So the longer holding period is beneficial. If you are in this situation, your loss from the sale may not be as much as you originally think though because basis (cost for tax purposes) is equal to the lesser of actual cost or the property’s fair market value when it’s converted to rental property.
As you can see from the above statements, it is a different situation for every taxpayer when it comes to looking at the conversion of a residence to a rental home. (Renting Your Home To A Relative) With proper planning and consultation with a CPA a taxpayer can take advantage of some tax benefits in doing this as well as stay away from any tax pitfalls that could arise. Give us a call today 770-856-1309 if you would like to discuss your situation.