Tax Consideration of Converting Your Home Into A Rental Property

Tax Consideration Of Converting Your Home Into A Rental Property

tax consideration of converting your home into a rental property

Tax Consideration Of Converting Your Home Into A Rental Property

Analyzing the decision to rent the property combined with the prospect of selling the home down the road may affect your decision. We usually look at the hypothetical sales transaction from the perspective of selling the property at gain or loss.

Tax Consideration Of Converting Your Home Into A Rental Property

When a personal residence is sold at a gain, the transaction may qualify for the “home sale tax exclusion.” To qualify for this the homeowner must own and live in the home as the principal residence for at least two of the last five years. When the taxpayer/taxpayers meet all the requisites for the exclusion, they can exclude $250,000 gain if they are single and they can exclude $500,000 gain if they are married.

When a personal residence is sold at a loss, tax law considers this a non-deductible personal expense. To deduct losses on the sale of property it must be considered a business or investment property. Converting a personal residence into a rental property means that it is business property.

This is a pretty easy tax planning situation. Some taxpayers may consider going to their CPA firm to review the effect of the decision. This will cut down on unpleasant situations later when the returns are being prepared after the events have occurred.

Rental Property Conversion

When someone becomes a landlord the rental income and expenses incurred to maintain and operate the home are combined to calculate the net income or loss. Losses are limited by passive activity loss rules (PAL). Deductible expenses include utilities, repairs, and depreciation.

Depreciation is an interesting concept that may generate losses. For example, consider a home is rented out for what it costs to run it, because the home is located in bad neighbourhood and the owner is waiting for the market to recover. Most people think they would break even when calculating the income or loss, however depreciation is like a phantom deduction that may create a loss.

A tax deduction from gross income is allowed as a matter of legislative grace. Here is a famous tax quote from a justice of the Supreme Court, “Whether and to what extent deductions shall be allowed depends upon legislative grace; and only as there is clear provision therefore can any particular deduction be allowed.” [1] The passive activity loss rules (PAL), deny a loss deduction unless one of the following exceptions apply.

The following are the exceptions wherein PAL rules do not apply on a taxable year:


  1. Adjusted Gross Income (AGI) is less than $100,000; the loss deduction is phased out completely when AGI is more than $150,000.

  2. Active participation in the lease operation

  3. Losses arising from rental activities are less than $25,000

When a rental property owner sells a property at a loss, the loss is deductible for tax purposes on a premise that the taxpayer can substantiate the conversion of the real property into a permanent rental property. Renting out the home until it is sold does not satisfy this requirement. A longer the lease term portrays the situation as business decision to make the home into a permanent rental property.

There is also another shade of gray tax law decision, establishing the fair market value of the property when it is rented out. For tax purposes, the value of the property placed in service is the lesser of the historical cost or the market value of the property when it is placed in service. The lower the fair market value of the property is, the lower the deductible loss will be.

For example, consider a property which originally cost the owner $500,000 with a fair market value of $300,000 at the time of conversion. The home is sold later for $250,000; the amount of loss would only be $50,000.

We hope this article was helpful. This article is an example for purposes of illustration only and is intended

[1] New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934)

http://www.cpafirmsouthflorida.com

We can help review the decision to turn a principal residence into rental property.

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