- Discover reasons homeowners convert homes to rentals.
- Learn how a home’s basis affects conversion-related tax issues.
- Find out how depreciation factors into converting a home into a rental.
- Learn about cash flow versus tax profit or loss.
- Discover the limits of passive loss deductions.
- How will the home gain exclusion impact your taxes when you decide to sell your rental home?
- Discover other tax issues pertinent to this topic.
- Find out what you need to know about becoming a landlord.
With the current substantial appreciation in home values and demand for housing exceeding the available inventory, along with low home mortgage interest rates, more and more homeowners are converting their existing homes into rentals when they buy a new home. However, homeowners converting a home into a rental need to consider some important tax issues.
Some individuals may make the conversion to maximize the tax benefits for an elderly person who can no longer live alone by delaying the sale of that person’s home or to ensure that a home provides value when its owner takes a temporary job assignment in a different location.
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 making a conversion, several tax matters come into play when making that decision. Fiducial has more information below.
Start With the Basis When Converting a Home Into a Rental
The basis of the converted property is a good place to start examining these conversion-related tax issues. We use the starting value, or basis, to calculate gains or losses for tax purposes. We also use the basis to determine the amount of depreciation that can be claimed for property used in the rental activity.
Generally, for depreciation purposes, a property’s depreciable basis on the date of the conversion equals the lower of its adjusted basis (the original cost, plus the costs of any improvements, minus any 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 had been 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:
What 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:
(1) If the owner of the rental subsequently sells for a loss, the basis for loss equals 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.
(2) If the owner of the rental home subsequently sells for a profit, the basis for the gain equals the property’s adjusted basis.
How Does Depreciation Factor Into Converting a Home Into a Rental?
Depreciation is an allowance that accounts for wear and tear. It also provides. a systematic way for the owner to recover the initial investment in the property. This is necessary because tax law doesn’t allow homeowners to deduct 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).
Want to know how to determine the depreciation for a residential rental? First, reduce the basis by the value of the surrounding land (as land is not depreciable) to get the value of the improvements to the home (i.e., the structure). Then, multiply that value by .03636 (the annual depreciation rate).
In the conversion year, the resulting amount has to be prorated by the number of months used as a rental. Generally, the value of the land is based on a property-tax statement.
For example, if a property-tax statement values an entire property at $240,000 and its land at $80,000, then 1/3 of the basis ($80,000 / $240,000) is allocated to land. We allocate the remaining 2/3 to improvements. Thus, if the basis equals $300,000, then the value of the depreciable improvements equals $200,000 (2/3 × $300,000). The annual depreciation deduction equals $7,272 (.03636 × $200,000).
Rental Cash Flow versus Taxable Profit or Loss
Cash flow is the net amount after subtracting expenses from rental income. The 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.
The major difference between cash flow and taxable income is that cash flow includes the deduction for the entire mortgage payment (not just the interest) but does not include the deduction for depreciation. In the above example, the rental has $1,600 in positive cash flow for the year. However, it 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. Deductions from passive losses have a limit of $25,000 per year for most taxpayers with AGIs of $100,000 or less. This limit ratably phases 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: The passive losses in excess of this limit carry over to future years. They can be used to offset other passive income in those years. In addition, any unused carryforward amount and any passive losses in the sale year are deductible in full once the rental is sold.
Home Gain Exclusion
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. The amount that can be excluded jumps to $500,000 for married couples who are filing jointly – provided that both have used the property as a primary residence for 2 out of the prior 5 years and at least one has owned the property for 2 out of the prior 5 years.
This is a very important consideration because, once a home is converted into a rental, the homeowner(s) will lose 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 period expires, any depreciation that was claimed during the rental period must be recaptured as taxable income.
Other Tax Considerations for Rentals
This article has covered only some of the tax issues affecting rental properties. Others include the qualified business income deduction available for trade or business owners. This generally includes landlords, requirements to issue 1099 forms to service providers, and special rules for real estate professionals.
If you have a “homeowner’s exemption” on your home for real estate tax purposes, in most jurisdictions when you convert the home to a rental you will no longer be eligible for this exemption. So, you should expect to pay higher property taxes.
Being a landlord will come with some problems, such as repairs and maintenance. Of course, you also have to make sure you rent to responsible tenants. Don’t wish to deal with landlord responsibilities? Management firms are generally available for a fee, which counts as a rental expense for tax purposes.
The benefits of renting include cash income, tax write-offs, and most of all, long-term appreciation of the property. But not all circumstances warrant converting a home to a rental versus selling it. Need assistance with the financial and tax aspects and the pros and cons of converting? Call Fiducial at 1-866-FIDUCIAL or make an appointment at one of our office locations to discuss your situation.
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