6 Tax Implications of Turning Your Home Into a Rental
Thinking about converting your home into a rental property?
It's not as straightforward as putting a sign in your window. Becoming a landlord comes with certain costs, responsibilities and protection costs you are definitely going to want to take on. Get ready to start tallying every cost coming out of your home's worth due to depreciation, and the dollars going into its value from tenants and improvements.
Most of all, make sure you understand the tax implications before becoming a landlord.
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From Personal to Business Asset
The IRS considers your primary residence a personal asset and limits what expenses you can deduct. These include mortgage interest and property taxes, but to deduct them, you'd have to itemize your personal deductions. Plus the federal government caps your state and local tax (SALT) deductions at $40,000.
As a business asset, virtually all expenses become deductible on Schedule E of your return. That means you can take the standard deduction and still deduct all property-related expenses. These include not just mortgage interest and property taxes, but also insurance, repairs, maintenance, HOA fees and even travel to visit the property. The catch is you'll end up documenting everything.
"When you become a landlord, you must start maintaining organized, detailed and accessible records," notes CPA Courtney Sexton with TurboTenant.
Depreciation
Not only can you deduct all those real expenditures, but you can also deduct the "paper expense" of depreciation.
For a residential property, that means dividing the building value by 27.5, which you can then deduct each year for the next 27.5 years. Just be aware that you'll owe depreciation recapture upon sale — regardless of whether you took the depreciation or not.
Loss of Homestead Exemption
Many states cap property tax bills or increases for primary residences. But not for rental properties.
Check your state's rules on homestead exemptions and beware that your property tax bill could go up after converting it to a rental.
Clock Ticks for 121 Exclusion
When you sell a primary residence, the IRS excludes the first $250,000 of capital gains ($500,000 for married couples). It's called a Section 121 exclusion or homeowner exclusion.
To qualify for it, you must have lived in the property for at least two of the last five years. So, you can technically rent out the home for three years after moving out and still sell it with the homeowner exclusion.
Cost Basis Implications
Your cost basis is likely lower for your home than it would be if you bought a new rental property.
"When you convert the home, your depreciable basis becomes the lower of either your adjusted basis (price plus improvements) or the market value when you begin renting it," explains Ryder Meehan of TaxDrop.
That said, you can potentially solve two tax problems simultaneously by selling the property to your own S-corporation or other entity. That can reset the cost basis, while segmenting off the gains tax-free under the homeowner exclusion. Talk to a tax professional before trying this at home though.
1031 Exchange Available
When you sell an investment property, you can also postpone paying capital gains taxes on it by putting the proceeds toward a new investment property. Known as a 1031 exchange, you won't owe capital gains tax until you sell the new property.
Still, it requires jumping through bureaucratic hoops, including hiring a "qualified intermediary." Read up on the IRS rules of 1031 exchanges before attempting it.
This article was provided by MoneyLion.com for informational purposes only and should not be construed as financial, legal, or tax advice.
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