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Converting Your Home to Rental Property

The Benefits and Pitfalls

By: Susan Liniger, Goodman & Company

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You have moved to another residence, but find it difficult to sell your present home.  One way to weather a soft residential selling market is to rent out your present home until the market improves.  You should be aware, however, that renting out your personal residence carries potential tax pitfalls.

You are generally treated like a regular real estate landlord once you begin renting your home to others.  That means that you must report rental income on your return, but also are entitled to offsetting landlord-type deductions for the money you spend on utilities, operating expenses, and incidental repairs and maintenance (e.g., fixing a roof leak).  Additionally, you can claim depreciation deductions for your home.  You can fully offset your rental income with otherwise allowable landlord deductions.  However, under the tax law passive activity loss (PAL) rules, you may not be able to currently deduct the rent-related deductions that exceed your rental income unless an exception applies.  Under the most widely applicable exception, the PAL rules won't affect your converted property for a tax year in which your adjusted gross income doesn't exceed $100,000, you actively participate in running the home-rental business, and your losses from all real estate activities in which you actively participate don't exceed $25,000.

Potential tax pitfalls may arise from the rental of your residence.  Unless your rentals are strictly temporary and are made necessary by adverse market conditions, you could forfeit an important tax break for home sellers if you finally sell the home at a profit.  In general, you can escape taxation on up to $250,000 ($500,000 for certain married couples filing join returns) of gain on the sale of your home.  However, this tax-free treatment is conditioned on your having used the residence as your personal residence for at least 2 of the 5 years preceding the sale.  So, renting your home out for an extended time could jeopardize a big tax break. 

Even if you don't rent out your home so long as to jeopardize your principal residence exclusion, the tax break you would have gotten on the sale will not apply to the extent of any depreciation allowable with respect to the rental or business use of the home for periods after May 6, 1997.  A maximum tax rate of 25% applies to this gain (attributable to depreciation deductions).  Some homeowners who bought at the height of the market may ultimately sell at a loss.  In such cases, the loss is available for tax purposes only if the owner can establish that the home was in fact converted permanently into income producing property, and isn't merely renting it temporarily until the home can be sold.  In this situation a longer lease period helps the owner.  However, if you are in this situation, you should be aware that you probably won't wind up with much of a loss for tax purposes.  That's 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.  So if a home was bought for $300,000, converted to rental property when it's worth $250,000, and ultimately sold for $225,000, the loss would only be $25,000.

The question whether to turn a principal residence into rental property isn't easy to resolve.  It's important to fully understand the ramifications of your decision, and so you should consult your tax advisor to help guide you to the right answer for your situation.

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