If you're planning to move out of your current home, you face a tough question: Should you sell your home, or would it be more beneficial to convert it into an income-producing rental property? Regarding selling prices and rental rates, the residential real estate market has cooled off in many areas—holding on to your property might seem like a solid investment. There are also tax implications to factor into your decision.
Rental Property Write-Offs
You can claim tax write-offs to offset the income if you convert your home into a rental property. For example, you can deduct mortgage interest and real estate taxes.
You can also write off all the standard operating expenses that go along with owning a rental property. Examples include utilities, insurance, repairs, maintenance, yard care, and homeowners' association fees. In addition, depreciation deductions are noncash expenses that can shelter some or all of your cash flow from federal income tax.
Using the straight-line method, you can depreciate the tax basis of a residential building (not the land) over 27½ years while the property may continue to appreciate. Such tax basis may not exceed the property’s fair market value when converted to rental. Your property's initial tax basis for depreciation usually equals the original purchase price minus the purchase price allocable to the land, plus the cost of improvements, minus any depreciation write-offs you've claimed over the years. For example, you might have written off depreciation from a deductible home office.
To illustrate the advantages of claiming depreciation, suppose you decide to convert your home into a rental. The tax basis for the property (excluding the land) is $700,000. Your annual depreciation deduction would be $25,455 ($700,000 divided by 27½ years). That means you can have up to $25,455 of positive cash flow each year from your rental property without having to share with Uncle Sam.
Beware of PAL Rules
Things can get complicated if your rental property throws off a tax loss. The passive activity loss (PAL) rules will usually apply. In general, the PAL rules allow you to deduct passive rental losses only to the extent you have passive income from other sources. Examples include passive income from other rental properties or gains from selling them. Passive losses in excess of passive income are suspended until you either have some passive income or sell the property that produced the losses.
As a result, the PAL rules can postpone rental property loss deductions, sometimes for many years. Fortunately, exceptions to the rules may allow you to deduct losses sooner rather than later.
Taxable Income from Rental Properties
Eventually, your rental property should start generating taxable income instead of losses because escalating rents may surpass your deductible expenses. Of course, you must pay income taxes on those profits. But if you piled up suspended passive losses in earlier years, you can use them to offset your current passive gains.
In addition, passive income from rental real estate can get hit with the 3.8% net investment income tax (NIIT) and gains from selling a rental property. The NIIT is on top of the regular income or capital gains tax rate. However, the NIIT only affects people with relatively high incomes. You may owe state income tax, too, if applicable.
Tax Treatment of Rental Property Sales
The expectation is that you'll eventually sell a rental property. If so, you'll have a tax gain to the extent that the net sales price exceeds your tax basis in the property after adding the cost of any improvements and subtracting depreciation deductions.
If you sell your former principal residence within three years after converting it into a rental, the federal home sale gain exclusion will usually be available. Under that deal, you can shelter up to $250,000 of otherwise-taxable gain (up to $500,000 if you're married). However, you can't shelter gains attributable to depreciation deductions. That part of your gain will be taxed at a 25% federal rate.
The tax results without the home sale gain exclusion are still favorable.
Section 1031 Exchange Option
The tax law allows rental real estate owners to sell appreciated property effectively, reinvest the proceeds and defer the federal income hit indefinitely. This strategy is called a Section 1031-like-kind exchange, named for the applicable section of the tax code.
With a Sec. 1031 exchange, you swap the property you want to sell for another property (the replacement property). You're allowed to defer paying taxes until you sell the replacement property. Or, when you're ready to sell the replacement property, you can arrange another Sec. 1031 exchange and continue deferring taxes.
The Sec. 1031 exchange rules provide flexibility when selecting replacement properties. For example, you can trade holdings in one area for properties in more-promising locations. You could also swap an expensive single-family rental house for a small apartment building, an interest in a strip shopping center, or even raw land.
Suppose you die while still owning the replacement property. In that case, current law gives your heirs a federal income tax basis step-up to equal the property’s fair market value as of your date of death — or as of six months later if the executor of your estate chooses. So, your heirs can sell the property and owe little or nothing to Uncle Sam.
To Rent or Not to Rent?
Converting a personal residence into a rental property can be a tax-smart move. But it's only right for some situations; there’s more to factor into your decision than taxes. Contact an R+R tax advisor to determine what's right for you.
Reynolds + Rowella is a regional accounting and consulting firm known for a team approach to financial problem solving. As Certified Public Accountants, our partners foster a personal touch with our clients. As members of DFK International/USA, an association of accountants and advisors, our professional network is international, yet many of our clients have known us for years through the local communities we serve. Our mission is to operate as a financial services firm of outstanding quality. Our efforts are directed at serving our clients in the most efficient and responsive manner possible, delivering services that exceed the expectations of those we serve. The firm has offices at 90 Grove St., Ridgefield, Conn., and 51 Locust Ave., New Canaan, Conn. For more information, please contact Elizabeth Bresnan at 203.438.0161 or email.
