Tax Impacts of Converting Your Home Into a Rental
There is a lot to consider in converting a residence into a rental. One of those considerations is the impact on income taxes. Rental income is taxable, but all the expenses of owning and maintaining the home are also deductible. These include mortgage interest, property taxes, repairs, utilities, etc. In addition there is a deduction for depreciation, which is a write off of the cost of the home over a period of time.
You can depreciate the tax basis of the building part of a residential rental property (but not the portion allocated to land) over 27½ years. Depreciation is nice because it allows you to take a deduction without having to pay out cash. However there is a special rule that applies to a rental property that was formerly your personal residence. Under the rule, the portion of the building’s cost that can be written off as depreciation is the lower of the building’s fair market value on the date it was converted to a rental property or the building’s original cost plus any improvements.
This same rule also applies if you have a loss on the sale of the property after it has been converted to a rental. However, if there is a gain on the sale it is possible to use the property’s regular basis. Regular basis generally equals the original cost of the land and building plus the cost of any improvements minus depreciation deductions claimed during the rental period. This rule can produce some strange situations – but nevertheless, it is the rule.
Depending on the amount of time that you used the property as a personal residence, as well as the amount of time it was used as a rental, you may be able to take advantage of an exclusion of gain that results when the property is sold. It is possible to exclude up to $500,000 of gain on the sale of a home used a personal residence for at least two years within the last five. So, if you have rented the property for no more than three years after the conversion date you will still be able to qualify for the exclusion.
This is only a simple explanation of the process. Give us a call if you’re thinking about converting your residence to a rental.
Greg Tanner – is a Tax Principal at Wertz & Company, LLP, a Professional Services Firm located in Orange County, CA that specializes in working with entrepreneurs along their journey to success.