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Tax Issues That Arise When Converting a Home into a Rental

by
Gordon W. McNamee
on
1/26/2020
Tax Issues That Arise When Converting a Home into a Rental

Note: The tax filing and payment deadline for 2019 tax returns has been delayed from April 15, 2020 to July 15, 2020.

If you are considering monetizing your currently owned home by making it available for rent, it's not as straightforward as just hanging up a “For Rent” sign and pocketing the extra cash. Converting a home into a rental has real tax consequences that need to be considered, so whether you are looking to produce income from a previously owner-occupied home that you haven't sold or are renting out an empty property while you're away on a job assignment, there are important things that you need to know. Here are just a few.

What is the Property's Basis?

Many people decide to put a home up for rent mistakenly thinking they can recoup losses when the home's value falls. In order to understand how this works, the first thing you need to know is the property's basis.

Basis is the value from which gain or loss upon sale is determined for tax purposes. Basis generally starts with the purchase price and increases when improvements are made and decreases when a casualty loss on the home is claimed and when certain home-related tax credits, such as solar, are claimed. Basis is also reduced by any depreciation (depreciation is a tax allowance for wear and tear) claimed when it is used as a rental. When a property is converted from personal use to business use, such as a rental, the basis from which depreciation is determined is the lesser of the property's adjusted basis or the fair market value (FMV) at the date of the conversion.

Example #1: Michael bought a home for $250,000, then finished the basement and added a bathroom at a cost of $50,000. When he decided to convert the property into a rental, he hadn't suffered any type of casualty loss or claimed any home credits, so the adjusted basis is $300,000 ($250,000 + $50,000). To calculate what the depreciable basis is, he needs to compare that adjusted basis to the property's fair market value, or FMV. In this case the FMV is $350,000. The adjusted basis is lower than fair market value, making his depreciable basis on the property the lower of the two, or $300,000. If the FMV were $225,000, then that would be the depreciable basis because it is the lower of the two numbers.

Some people believe that when their property has fallen in value, as in the example provided above, they can just list the house as a rental and then take the loss (which you can't do with the sale of personal property). To prevent this, the tax law requires that when the fair market value of a converted property is less than its adjusted basis on the date that it is converted, it is the fair market value that is used to calculate the loss, not the higher adjusted basis. If, however, the rental property is sold and the property owner makes a profit, then the adjusted basis is used for calculating the gain. The property retains two different bases, and the one that is applied depends upon whether the sale results in a gain or a loss.

Property Depreciation

The next thing that a property owner who is considering renting a home needs to know about is depreciation. When you put a residence that you own up for rent, there is an expectation that it will not remain in pristine condition. There will be wear and tear that works against the owner's property value over time. To account for this, tax law provides an annual allowance that lowers its overall value by a small percentage each year that it is up for rent.

In light of the fact that most residential property actually goes up in value rather than down, the fact that a rental property is automatically entitled to a depreciation allowance usually results in considerable write-off that provides a big tax benefit. 

To figure out what kind of depreciation you will be looking at for converting a residence into a rental, start by subtracting the value of the land on which your property is located from the property's basis. You need to do this because only the property depreciates; land does not.

You can generally get the land's value by checking your most recent property assessment or tax bill. The resulting number will reflect any additions or improvements that have been made to the property. Taking that number, multiply by the depreciation rate, which is currently set at .03636.  This factor will be adjusted for the first and last year that the property is a rental to reflect the number of months the property is in business use.

Example: Grant owns a home. His property tax bill reflected a total value of $240,000, with $80,000 attributed to the land itself. That means that $160,000 (or 2/3 of its value) is the amount reflected as an improvement. If the property's basis is determined to be $300,000, you determine what 2/3 of $300,000 is to find its depreciable improvements – that would be $200,000 — and then multiple that $200,000 depreciable improvement amount by the annual factor of .03636 to arrive at an annual depreciation of $7,272. If Grant didn't put the home into rental status until August 1, his depreciation factor for the first year would be .01364 (.03636 x 4.5/12) and the depreciation would be $2,728 ($200,000 x.01364) – only a half month's depreciation is allowed for the first month.

Is Renting Your Property Worth It?

To determine whether it is worthwhile to rent out your property, you want to determine what your rental cash flow is and what your taxable profit or loss is. The table below provides an easy-to-understand comparison of the two. All you really need to know to understand the difference is that cash flow is what is left after you deduct your rental expenses from your rental income, but doesn't include what you can deduct for depreciation. Taxable income is the rental income you receive less the amount that you can deduct.

If your venture into owning a residential property ends up losing money, it is known as a passive loss. You are only able to offset this type of loss with passive income, and the government limits the amount of real estate rental passive loss that can be deducted based on Adjusted Gross Income (AGI). If your AGI is $100,000 or less, you can write off up to $25,000 per year of real estate rental losses, but once your income goes above that threshold your limit starts phasing out, and anybody whose AGI is over $150,000 cannot deduct any real estate rental passive loss at all. If your passive losses exceed the amount that you are permitted to deduct in each year, you can carry the balance forward to future years to balance passive income. You can also deduct those losses in full in the year that you sell the rental property or reduce other passive income.

How Renting Could Affect an Eventual Sale

If you are considering selling a property that you've owned for several years and that you lived in for a period of time, it is important to remember that renting it prior to selling it can eliminate an important tax benefit available to long-time homeowners. That benefit is the $250,000 tax exclusion on gains from a home sale ($500,000 for a married couple filing jointly).

That exclusion, which is offered under IRC Section 121, negates taxes on the exclusion's gains as long as the property was owned by the taxpayer and used as the owner's primary residence for at least two of the five years before the property is sold (and in the case of a married couple, that at least one has owned the property for two out of the last five years). If you decided to rent out your property and have not lived in it as your primary residence for three years or more, you can't exclude any of the gain because you can no longer say that you've met the two-out-of-five year requirement.

If, as in the example above, you sell your property prior to hitting the point where you no longer qualify for the exclusion, you still need to remember to report the depreciation you took during the years that it was rented, as it is considered taxable income.

As appealing as it may seem to use your home for rental income, doing so comes with a fair amount of tax complexity. Make sure that you know what you're getting into and what its ramifications will be for you before pursuing this major endeavor. It's highly recommended to discuss your plans with a tax professional before proceeding. You'll want to discuss the differences between renting via a short-term platform like Airbnb or VRBO vs. a long-term rental to a specific tenant.

Gordon W. McNamee, CPA writes for TaxBuzz, a tax news and advice website. Reach him and his team at [email protected].

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Gordon W. McNamee

Gordon W. McNamee

Gordon W. McNamee is a Certified Public Accountant (CPA) based in Rancho Cucamonga, CA. Gordon W. McNamee can assist you with your tax return preparation, payroll, accounting and tax planning needs. <br /> <br /> 2021 is Gordon W. McNamee, CPAs 38th year in the profession. As as a former IRS agent (1984 through 1987), Gordon has been in public accounting since 1987. Gordon specializes in individual, corporate, HOA, trust, estate and payroll taxes. He also prepares financial statements and provides accounting & bookkeeping services. He enjoys making his clients feel at ease while providing a personalized professional service.

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