Should you convert your home to a rental?

By David Katzman

If the recent residential real estate slump has left you unable to sell your home, you may be considering renting. There are, of course, advantages and disadvantages associated with renting, but you may also want to weigh the federal tax consequences before making your final decision.

For example, if you make money from your rental, you’ll need to report that income on your return and pay taxes accordingly. To determine the final taxable amount, you are allowed to deduct your expenses, such as the cost of maintenance and repairs, property taxes and any other operation expenses. You can also deduct for depreciation.

If your total deductions exceed your rental income, the passive activity loss (PAL) rules may restrict you from deducting a loss, unless you meet the qualifications for an exception. You fully meet these qualifications if your adjusted gross income for the tax year is less than $100,000, you have actively managed your rental or rentals, and your total losses for those rentals does not exceed $25,000.

Protecting your capital gains

If you are renting your home temporarily, such as while waiting for the real estate market to improve; you’ll want to guard against inadvertently losing your capital gains exclusion. Generally, a single taxpayer can shelter from federal income taxes a maximum of $250,000 in capital gains on the sale of their principal residence. For married couples, this tax break can be as much as $500,000.

However, there is one significant condition. You must have lived in your principal residence for at least two of the previous five years. If you have not yet lived in your home for at least two years or you rent your home for an extended period, you could jeopardize this capital gains exclusion.

Even if you still qualify for an exclusion, after May 6, 1997 any depreciation available to you during the time your home was a rental will be “recaptured” when you sell; and you’ll owe taxes on that amount. The maximum tax rate on allowable depreciation—for either rental property or for the portion of you home you used for business—is 25 percent.

What happens if you sell at a loss?

If you bought your home at a market peak, turned it into a rental and then sold it for a loss, you may be able to take a tax deduction. However, you’ll need to establish that your home was permanently converted to a rental. In this case, a long lease or a long rental history will help. Unfortunately, your deduction may not be as large as you would like, either. It is based on which ever is lower—the original cost of your home or the fair market value at the time it was converted to a rental. In a falling market, the value at conversion is probably lower. For example, if you purchased your home for $350,000 and converted it to a rental when its fair market value was $300,000, this lower amount is your “basis.” If you then sell your home for $275,000, you would calculate your loss, for tax purposes, by subtracting $275,000 from $300,000 (or $300,000 less any depreciation deducted). Your loss would be just $25,000.

As you can see, converting your home to a rental requires weighing a number of factors. If you are considering this option, a tax professional can help you determine the tax implications for your particular situation.

David A. Katzman is a certified public accountant licensed to practice in the State of Florida and the Commonwealth of Massachusetts. He is also a certified financial planner and certified senior advisor. Please consult your tax advisor for details and assistance in applying this general information to your specific situation.