Thinking of Converting Your House to Rental Property?

By Teresa Ambord

With more and more people turning to real estate for investment, many are buying bigger houses for themselves and turning their old homes into rentals.

Depending on where you live, that plan can add substantial cash flow to your monthly income.  But you should know, converting residential property to rental property is no simple task.  Before you do it, sit down with a trusted accountant and be sure you understand the tax implications.

The Gain

You probably know that if you sell your principal home at a gain, you may be able to exclude up to $250,000 of that capital gain from being taxed.   If you’re married and file a joint tax return, you can deduct $500,000. But to qualify for the exclusion you have to pass the “use” and “ownership” tests. That means you must have owned and lived in the home as your principal residence for two of the last five years.  To claim the joint exclusion for married couples, at least one spouse must pass the ownership test, and both must pass the use test.

If you have lived in the house for less than the required two years, you may still qualify for a partial exclusion (prorating the number of months of residence by the exclusion amount.  So if you’ve lived there 18 months, the calculation would be 18months/24months x $250,000 for a single person.)

Converting to Rental

Now suppose you decide to rent your house out for the next few years while you store your stuff in your mom’s garage and do a backpack tour of Europe.  When you return, you want to sell the home you converted to a rental.  To exclude the capital gain, you must pass the same tests of use and ownership that you would’ve had to pass before the house became a rental.  If you haven’t lived in the home as your main residence for two of the past five years, you will either have to pay tax on the capital gain, or evict your renters, and live in the house for two years before you sell it.

Depreciation Deduction for Your Rental

While you are renting out the house and naturally, claiming the rental income on your tax return, you can take a deduction for depreciation on the house.  Your basis for figuring the deduction works like this:

The depreciable basis will be, the lesser of the purchase price for the house (less the cost attributable to the land) plus the cost of improvements (not repairs), or, the fair market value of the house at the time you converted it to a rental.   So if you bought the house and land for $150,000, and the land was worth $50,000 but now the house is worth $400,000, your depreciable basis is $100,000 (the purchase price of $150,000 minus the amount attributable to the land, $50,000).   Residential rental property is depreciated over 27.5 years, meaning the depreciable basis of $100,000 needs to be spread over those 27.5 years to be fully deducted.

If, in the meantime, you sell that property, you will have to recapture some of that depreciation deduction by paying capital gains tax on it, probably 25 percent (for rental use after May 6,1997).  So if you rented the house out for three years and deducted $10,000 of depreciation, you will likely owe capital gains tax of 25 percent, or $2,500, when you sell.

Don’t Go It Alone

As you can see, the decision to convert your home into rental property involves complex issues.  Since presumably you are making the conversion to create a cash flow for yourself now or a way to provide retirement income later, the last thing you want to do is end up handing a large percentage of your gain over to Uncle Sam.   Before that happens, spend some time with an accountant well versed in real estate transactions.

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