You have decided
to move to another residence, but find it difficult to sell your present home.
One way to weather a soft residential selling market is to rent out your
present home until the market improves. If you are thinking of taking this
step, you no doubt are fully aware of the economic risks and rewards. However,
you also should be aware that renting out your personal residence carries
potential tax benefits and pitfalls.
You generally
are treated like a regular real estate landlord once you begin renting your
home to others. That means you must report rental income on your return, but
also are entitled to offsetting landlord-type deductions for the money you
spend on utilities, operating expenses, and incidental repairs and maintenance
(e.g., fixing a leak in the roof). Additionally, you can claim depreciation
deductions for your home. You can fully offset your rental income with
otherwise allowable landlord-type deductions. However, under the tax law
passive activity loss (PAL) rules, you may not be able to currently deduct the
rent-related deductions that exceed your rental income unless an exception
applies. Under the most widely applicable exception, the PAL rules won't affect
your converted property for a tax year in which your adjusted gross income
doesn't exceed $100,000, you actively participate in running the home-rental
business, and your losses from all rental real estate activities in which you
actively participate don't exceed $25,000.
You should also
be aware that potential tax pitfalls may arise from the rental of your
residence. Unless your rentals are strictly temporary and are made necessary by
adverse market conditions, you could forfeit an important tax break for
home sellers if you finally sell the home at a profit. In general, you can
escape taxation on up to $250,000 ($500,000 for certain married couples filing
joint returns) of gain on the sale of your home. However, this tax-free
treatment is conditioned on your having used the residence as your principal
residence for at least two of the five years preceding the sale. So renting
your home out for an extended time could jeopardize a big tax break. Even if
you don't rent out your home so long as to jeopardize your principal residence
exclusion, the tax break you would have gotten on the sale (i.e., exclusion of
gain up to the $250,000/$500,000 limits) will not apply to the extent of any
depreciation allowable with respect to the rental or business use of the home
for periods after May 6, 1997, or to any gain allocable to a period of
nonqualified use (i.e., any period during which the property is not used as the
principal residence of the taxpayer or the taxpayer's spouse or a former
spouse, such as a rental) after Dec. 31, 2008. A maximum tax rate of 25%
applies to this gain (attributable to depreciation deductions).
Some homeowners
who bought at the height of a market may ultimately sell at a loss. In such
situations, the loss is available for tax purposes only if the owner can
establish that the home was in fact converted permanently into income-producing
property, and isn't merely renting it temporarily until he can sell. Here, a
longer lease period helps an owner. However, if you are in this situation, you
should be aware that you probably won't wind up with much of a loss for tax
purposes. That's because basis (cost for tax purposes) is equal to the lesser
of actual cost or the property's fair market value when it's converted to
rental property. So if a home was bought for $300,000, converted to rental
property when it's worth $250,000, and ultimately sold for $225,000, the loss
would be only $25,000.
The question of
whether to turn a principal residence into rental property isn't easy to
resolve. We can review your situation in detail and guide you to an answer that
makes the most sense for you. Contact us
at http://www.lwhcpa.com/contactus.
