Financial Advisor Insights

Converting Your Home Into a Rental Property

by Kristin McFarland, CFP® on October 19, 2016 in Real estate, Home buying

The IRS defines a primary residence as a living space which you inhabit, but may rent out for up to two weeks per year without paying tax on the rental income. A rental home is primarily used as an income property, where personal use does not exceed the greater of 14 days or 10 percent of the days the home is rented annually. If you are planning on turning your primary residence into a rental property, first understand the tax and financial considerations and discuss with your financial advisor how real estate investments may fit into your overall goals. Finally, the tax code is very complex. It is advisable to work with a certified public accountant (CPA) on your personal situation.

Once you make the conversion, taxes on the property will be handled differently. The rental income will be taxable, but you may also be allowed to deduct expenses for maintaining the property, in addition to depreciation. Also, when the rental is eventually sold, 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 IRS allows landlords to claim deductions on their income taxes for depreciation and take other write-offs for rental properties. The deduction for depreciation can be used to offset the property’s rental income. Here is a breakdown of possible rental property deductions:

  • Mortgage interest expense
  • Property taxes
  • Insurance
  • Association fees (HOA dues)
  • Utilities
  • Repairs and maintenance

In most situations, under the passive activity loss (PAL) rules, you cannot write off deductions that are more than the sum of the rent received.

Tax basis for depreciation

Although 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 money spent on capital improvements that have added value to the property, prolonged its life, or adapted it for a new use.


For example, a qualified improvement may include additional square footage or landscape improvements. Regular repairs and maintenance are not considered qualified improvements.

When a personal residence is converted to rental property, you need to know the basis for depreciation. This is the lower of your adjusted basis in the residence at the date of conversion (purchase price + qualified capital improvements), or the fair market value of the property at the time of conversion. In general, you must depreciate a residential rental property over a 27.5 year period. Depreciation, however, only applies to the income-generating portion of the home and does not apply to land.

Financial and tax considerations before investing in a rental propertyThe IRS provides depreciation tables to assist in determining the depreciation expense to recognize each year. However, to add to the complexity of this calculation, each of the assets may have a separate life. For example, the structure itself is based on 27.5 years but appliances have a seven year life for depreciation purposes. Consult with your tax advisor to help ensure you are preparing your taxes properly.

Selling the property

With a personal residence, you cannot deduct the depreciation expense as you can with a rental property. To calculate the capital gain (or loss) when selling a converted 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 you sell the property 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 you sell at 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 to a rental.

Here’s a high-level example:

Lily moved out of her house and began renting it out. She originally paid $400,000 for the property: the assessed value of the land was $50,000 and the home was $350,000. When the home was converted to a rental on Jan. 1st its fair market value was $495,000, of which $70,000 was land. Ten years later, she sells the property for $610,000.

1

Original cost

 $      350,000

2

FMV at conversion

 $      425,000

3

Depreciation taken

 $      127,273

4

Adjusted basis if sold at gain (#1 - #3)

 $      222,727

5

Adjusted basis if sold at loss (lesser of #1 - #3 or #2 - #3)

 $      222,727

6

Sale price

 $      610,000

7

Capital gain (#6 - #4)

 $      387,273

 

For simplicity, the example above excludes the potential impact of carryover losses and depreciation recapture. At a high level, depreciation recapture means paying tax on a portion of the depreciation deductions you received. Depreciation recapture tax is assessed at a different rate (25 percent in 2016) and only applies to the lesser of the gain or depreciation already taken. Again, consulting a tax professional is advisable.

New Call-to-actionHome sale exclusion for a primary residence

Converting your home to a rental property without a plan in place may end up costing you big in the end. If you only plan on renting the home for a few years before selling, you could miss out on a big tax break.

If you had sold the property while it was still your primary residence, or within the allowable timeframe after converting to a rental, you could have received the home sale exclusion to minimize – or eliminate – the tax you’ll owe after the sale. In 2016, single filers may exclude gains up to $250,000 ($500,000 if married filing jointly) from their taxable income.

To qualify for the exclusion, the property must have been your primary residence, you must own the property (ownership test), and have lived in the home for at least two of the last five years (use test). If you are married, only one of you needs to satisfy the ownership test but you both need to meet the use test. Further, you are only allowed to claim the exclusion once every two years. If only one spouse meets the criteria, the allowable exclusion will be based on $250,000.

Unless you plan on being a landlord for a long time or only intend to rent the property for a few years before returning to live there, it likely makes the most financial sense to sell the home when you move out, assuming you can expect a sizable gain.

Other landlord considerations

Being a landlord can be a lot of work. Make sure you’re up to the task before renting your property. For example, a property that might be fine for you as an owner-occupant may not meet code for a rental. Stairs are a common example – grading and safety rails may need to be improved. Landlords will need to learn relevant local laws and acceptable forms of tenant screening to ensure compliance.

In the event a tenant does not pay rent, you may have to start an eviction process, which often takes months and may involve costly legal fees. Furthermore, certain states, such as Massachusetts, have very strict tenant rights and laws that can make it very difficult for the landlord to win in the event of a dispute.

Make sure to understand your cash flows before becoming a landlord. Based on the market rate of rents in the area, you may decide the expected monthly pre-tax income isn’t enough to justify your time to manage the property. If your projected profit margin is too small, then even smaller repairs like a hot water heater could take months to break even.

Consider the vacancy risk of the neighborhood as well. Popular urban areas typically have a larger pool of reliable tenants to choose from and can command a higher monthly rent. The income and upside potential of holding onto the property over time must be sufficient to cover the added time and financial risk of the rental property.

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