Have you ever thought about turning your home into a rental house? Or on the flip side, change your rental back into your personal residence? Both situations can have tax consequences that can either be good or bad, depending on the situation.
In today’s housing market, it may be very tempting to turn your house into a rental property to add some easy monthly income to your pocket. One of the advantages of doing this is the additional tax deductions that can be taken on your tax return. As a rental property, you can deduct items paid for the rental such as advertising, cleaning and maintenance, insurance, property taxes, mortgage interest, legal and professional fees, repairs, supplies, and utilities. In addition, your rental property will also be depreciated, which is a yearly deduction that requires no additional cash payment. If all these deductions result in a loss, netted against the rental income, this is considered a Passive Activity Loss. If your income is under $100,000, this loss can be claimed on your tax return for that year, up to a maximum annual deduction of $25,000 for “Married Filing Jointly” filers. If your income is over this amount, the loss may be suspended, but can be carried forward to be used on future tax returns. If the result is income at year end, since it is passive income, you will not pay any self-employment tax. The main downside to having a rental is the tax impact of selling the rental. If you sell your house for a gain, the amount of the property that was previously expensed as depreciation is subject to a higher 25% tax rate. The rest of the gain is taxed as long-term capital gains at a rate depending on your income tax bracket.
How does this situation change if you move back into your rental property, instead of selling it? When homeowners sell their personal residence, they may be eligible to claim an exclusion on the gain of this sale. The exclusion can be as much as $500,000 for taxpayers filing as “Married Filing Jointly”, or $250,000 for taxpayers filing as “Single”. If the property was once a rental, but is sold after you lived in the house, part of the gain can be excluded depending on the number of years you lived in the house out of the previous five years, and you will not have to pay taxes on this portion. This exclusion does not count for any depreciation taken while the property was a rental. All depreciation claimed when the property was a rental must be recaptured when the property is sold. As a personal residence, only mortgage interest and property taxes can be deducted. The rest of the expenses paid are no longer deductible on your tax return.
Both situations do have a few options to defer the gain or possibly eliminate the gain entirely. This could include a Step-Up in Basis, if the property was inherited, or a 1031 Exchange, if the property is an investment or rental property at the time of the exchange. If you are interested in more information and need a trusted tax advisor, please contact ADKF and we would be glad to assist you with any further guidance needed.