Homeowners who want to move sometimes decide to convert their principal residences into rental properties instead of selling them.  Renting out a former residence can be particularly appealing when a home can’t be sold for an attractive price because of unfavorable conditions in the real estate market.  Before making a decision to rent a home, it’s important to consider the potential tax effects.

Tax Treatment During the Rental Period

Overs report their rental income expenses on their personal income-tax returns.  Deductible expenses include money spent on advertising, cleaning and maintenance, insurance, mortgage interest, real estate taxes, repairs, and utilities.

A deduction for depreciation is also available.  Unfortunately, the depreciation period for residential rental property is quite long — 27.5 years.  And, if a home is worth less than its adjusted tax basis (typically, the home’s cost plus improvements) when the rental period begins, the annual depreciation deduction is based on the lower market value.

Even if a rental property is “paying for itself,” it may show a tax loss for the year because of depreciation.  When there is a loss, the tax law’s “passive activity” rules come into play.  Under those rules, a loss of up to $25,000 may be claimed against non-passive income (such as wages) if the owner actively participates in running the home-rental business.  The $25,000 loss allowance phases out with adjusted gross income between $100,000 and $150,000.*

Tax Treatment When the Property Is Sold

Homeowners generally don’t pay taxes on capital gains of up to $250,000 ($500,000 on a joint return) if they’ve owned and used their home as a principal residence for at least two of the five years before the sale.  But this tax break isn’t available for the sale of a residence that has been converted into a rental property unless the rental activity was temporary ad the sale takes place while the owner still meets the ownership and use tests.  Even then, gain is taxable to the extent of all depreciation that was (or could have been) claimed on the property.

What happens if the property is sold at a loss?  For the loss to be deductible, the owner must be able to establish that the property’s conversion into a rental property was meant to be permanent — not merely a temporary measure util it could be sold.

* The loss of allowance for a maried taxpayer filing separately is $12,500.  This allowance phases out with the adjusted gross income between $50,000 and $75,000.

Veihl Consulting Group, P.C.
Certified Public Accountant
1416 S. Gratiot Avenue
Mount Clemens, Michigan 48043
(586) 468-6611