Homeowners may consider converting their personal residence into a rental property for several reasons. They might, for example, want to diversify their investment portfolio, or the value of the home could have fallen below their purchase price. Whatever the reason, if you are thinking about making the move, you need to first weigh some tax and economic considerations.

Tax Considerations

The conversion of a personal residence to a rental raises several tax-related issues, including the following.

The Exclusion of Gains on a Home Sale
A conversion to a rental could affect your eligibility for the home sale gain exclusion. Under Sec. 121 of the Internal Revenue Code, taxpayers generally can exclude up to $250,000 (or $500,000 if married filing jointly) of gain on the sale of their principal residence.

The catch, when it comes to a potential rental conversion, is that you must have used the home as your principal residence for at least 24 months (or 730 days) out of the five years preceding the sale. So you would need to sell the home within three years of your rental conversion to benefit from the exclusion. If you do not, you forfeit the exclusion and could be subject to capital gains tax at a rate up to 20 percent.

The Role of Depreciation
When you convert your home to a rental property, you are allowed to claim depreciation on it. The basis for depreciation purposes is the lesser of 1) the adjusted basis on the conversion date, or 2) the property’s fair market value at that time. The adjusted basis is the purchase price you paid for the property (less the amount allocated to the land) plus the cost of any capital improvements.

Residential rental property is depreciated over 27.5 years. You can claim a prorated depreciation deduction for the basis every year over that period, increasing your cash flow and perhaps creating rental losses. For example, if your basis at conversion is $700,000, you can deduct $25,455 each year.

Bear in mind, though, that passive rental losses generally can be used to offset only passive income (some exceptions apply). If you do not have passive income, the losses are suspended until you do or you sell.

Moreover, depreciation deductions are recaptured as taxable income if you later sell the property at a gain. The portion of the gain related to your accumulated depreciation deductions is taxed at a rate of up to 25 percent, the so-called “unrecaptured Sec. 1250 gain” rate (the remainder is taxed at the applicable capital gains tax rate). In addition, any depreciation taken as a deduction is not excludable in the calculation of the Section 121 gain exclusion.  

The Deductibility of Renovations and Repairs
If you are planning to renovate the property, it may be wise to first convert it to a rental. While renovations on a personal residence are not deductible and will be added to the basis of the property and depreciated over 27.5 years, improvements made after conversion could be deducted in the year that they were incurred.  Under the “de minimis safe harbor rule” you can deduct up to $2,500 per invoice or item. This means that any small improvements or repairs can be deducted instead of capitalized and depreciated.

Economic Considerations

Of course, tax issues are not the only factors that warrant consideration. You could determine that economic reasons make a conversion advisable — or not. For example, converting a home to a rental property might improve its appeal for potential buyers. Even if you do not expect to sell in the near future, rents are ringing in at record highs in many areas of the United States, making rental real estate investments attractive to those looking for a healthy and steady stream of income.

On the other hand, rental properties come with their fair share of headaches. Demand peaks and flows, for example, so you could find yourself with extended vacancies that make it tough to cover the mortgage. You also must deal with tenants, repairs, and other hassles, or pay a property manager to do so, which will reduce the cash flow and profitability.

Related Read: Short-Term Rentals and Taxes: What Hosts Need to Know

Look Before You Leap

Converting your home to a rental property has several potential advantages, particularly when the returns on other types of investments are dropping and the value of rental property is climbing. Your personal circumstances matter, though — the benefits tend to be greatest for those in higher tax brackets who do not expect to rent the property for more than three years. We can help you determine whether conversion is right for you.

For more information, contact Kaleb Spreitzer at [email protected] or 312.670.7444, or ask your ORBA advisor. Sign up here to receive our blogs, newsletters and Client Alerts.