Tax Effects of Converting Your Primary Residence to a Rental Property

As the real estate markets around the country keep improving and interest rates remain at historic lows, this could create a great opportunity to convert your primary residence to a cash-producing rental property.  Are you looking to downsize, move, or simply looking for a long-term investment?  Whatever the reason, converting your primary residence to a rental property can be beneficial.  However, there are significant tax implications to consider.

Before you decide to convert your primary residence to a rental property you need to ask yourself a few questions:

  • What is the current fair market value of your property?
  • What did you purchase the property for, or what is your basis in the property?
  • How long do you plan to rent your property?
  • Will you be renting your property now and ultimately selling it in a few years?

It is important to answer each of these questions in determining whether converting makes sense.

Determining Fair Market Value of the Property

If you have decided to move forward with converting your primary residence into a rental property, the next step is to determine the fair market value of the primary residence.  The best way to obtain this number is to get the property appraised.  This appraisal allows you to calculate an accurate depreciation deduction.  You are allowed to depreciate the lesser of the fair market value at the date of conversion or your original purchase price (basis) in the primary residence over 27.5 years, and can also depreciate any improvements made. Keep in mind that you cannot depreciate land.  Depreciation reduces your taxable rental income received, thereby reducing your tax.  If the taxable rental income is reduced to a rental loss, the rental loss may reduce other taxable income on your individual income tax return.

Selling the Rental Property

If after a few years of renting, you decide to sell your rental property, this is when the answers to the questions above and tax planning become very important.   A taxpayer can exclude gain from income under Section 121 up to $250,000, or$500,000 for married couples filing a joint return, if:

A) Either or both spouses owned the residence for at least two out of the five years prior to the sale,

B) Both spouses have used the residence as their principal residence at least two out of the five years prior to the sale, and

C) During the two-year period ending on the date of the sale, neither spouse excluded gain from the sale of another home.

Calculating Gain or Loss on the Property

With proper tax planning, gain could be excluded from income under Section 121 on the disposition of the property (see example 1 below).  If the property is sold at a loss, the loss may or may not be deductible (see examples 2-3 below).  Depreciation recapture is another element that will impact the gain or loss and should be considered.  For simplifying purposes, the scenarios below have not taken into account depreciation recapture.

Example 1
Original Cost : $300,000
Fair Market Value: $400,000
Selling Price 4 years after purchase: $500,000
Result: $200,000 gain

This would result in a NON-TAXABLE $200,000 Capital Gain ($500,000 less original cost of $300,000 = $200,000 excludable Capital Gain on the sale of personal residence) as long as the property was your personal residence for two of the last five years and you have met the other criteria mentioned above to exclude the sale.

Example 2
Original Cost : $300,000
Fair Market Value: $275,000
Selling Price 4 years after purchase: $250,000
Result: $25,000 loss

This would result in a $25,000 Loss ($275,000 basis for determining loss less $250,000 selling price = $25,000 Loss.  The original cost of $300,000 less the $275,000 basis for determining loss of $25,000 is a non-deductible personal loss).

Example 3
Original Cost : $300,000
Fair Market Value: $250,000
Selling Price 4 years after purchase: $275,000
Result: No gain or loss

This would result in no Gain or Loss (selling price is between original cost and FMV at conversion basis).

Converting your primary residence to a rental property can be a great cash flow investment. However, it’s important to have a plan in place and to understand the tax implications of conversion.  It’s also important to remember the rules to be able to exclude the gain under Section 121. Your tax advisor can help you determine what rules and exceptions apply to you. For more information about converting your primary residence to a rental property, contact an Anders tax advisor today.