Although many people choose to sell their home before buying another one, that isn’t necessarily the right choice for everyone. Converting a primary residence to a rental property takes time, but if done right, can prove to drastically improve your passive income in just a few months.
Tenant demand for single-family rental properties in many markets is reaching all time highs and rents are still growing in some markets. The term “accidental landlords” is trending as homeowners who are trading up or otherwise relocating also try to hold onto their current low interest rate mortgages.
For some, it may make financial sense to turn an existing home into a rental instead of selling it, especially if the existing home was financed with a long-term mortgage at a low interest rate.
In this article, we’ll discuss potential benefits of converting a primary residence to a rental property, how taxes work, and key steps to take before becoming a landlord.
- Potential benefits of converting a primary home to a rental are tax deductions, rental income, depreciation expense, and tax loss carryforwards.
- One of the drawbacks to renting out a primary residence is paying capital gains tax when the property is eventually sold, although investors may benefit by performing a tax deferred exchange in the future.
- Steps to follow before turning a primary residence into a rental property include making sure an existing loan can be used for a rental, obtaining landlord liability and dwelling insurance, getting the home ready to rent, and selecting rental property software to track income and expenses.
Why convert a primary residence to a rental property?
When considering transforming your primary residence into a rental property, the initial motivation is often the potential to enjoy additional cash flow now and potential value appreciation down the road. Yes, of course, it’s natural to focus on how much more money you can generate each month by renting out your property, but some are unaware of the time and effort it takes to make it all happen.
Let’s dive into the benefits of converting a primary residence to a rental property with the necessary steps it takes to get things going. Here are four of the biggest benefits of turning a residence into a rental, along with an explanation of how they can work to your advantage.
For many investors, income from rental property needs to be reported to the IRS using Schedule E (Form 1040). However, the amount of income subject to tax is the net income after all expenses and tax deductions have been claimed. The tax implications of renting your primary residence out can vary depending on specific circumstances such as the location of the property, the number of days rented, and other factors.
Although every rental property is different, these are common expense deductions for a rental property:
- Auto and travel (must be mainly for business purposes)
- Cleaning and maintenance
- Commissions (paid for finding a new tenant or renewing a lease)
- Insurance (including homeowners insurance and landlord liability insurance)
- Legal and professional fees
- Management fees
- Mortgage interest
- Taxes (such as property tax)
- Utilities (sometimes paid directly by the landlord in small multifamily properties)
- Other owner expenses, such as dues and subscriptions or continuing education
To illustrate, assume a primary residence turned into a rental property generates $24,000 in annual gross rental income. If all of the expenses listed above total $18,000, the taxable net income would be $6,000.
Another benefit of converting a primary residence into a rental is the ability to depreciate the physical improvements, typically over a period of 27.5 years. As IRS Publication 946 explains, depreciation is an expense allowance for the wear and tear, deterioration, or obsolescence of the property.
To claim the depreciation expense, the cost basis of the property must be determined at the time the home is converted from a primary residence into a rental.
The cost basis used for depreciation in this situation is the purchase price of the home plus certain closing costs, plus qualified capital improvements (such as a new roof or other renovations). Alternatively, you can use the fair market value of the home at the time of conversion.
Depreciation applies only to the building and not the land. For example, if a home was valued at $250,000 at the time of conversion and the value of the lot was $30,000, the basis for depreciation purposes would be $220,000.
To calculate the annual depreciation expense, simply divide the basis by 27.5 years:
- $220,000 basis for depreciation / 27.5 years = $8,000 annual depreciation expense
When a primary residence is converted into a rental property, the owner can deduct the depreciation expense from the income the property generates to reduce taxable income.
Using the example above, if the rental property generated an income of $6,000 after tax deductions and the annual depreciation expense is $8,000, the owner would owe no tax on the income generated by the rental property:
- $6,000 income – $8,000 depreciation expense = <$2,000> loss for tax purposes
When a situation like this occurs, an investor has a passive activity loss (PAL) which we’ll discuss next.
Passive activity loss (PAL)
Generally speaking, the IRS considers rental real estate activities to be passive activities, even if an investor materially participates, such as visiting the property and meeting with the local property manager.
Under the passive activity rules, an investor usually cannot claim deductions that exceed the amount of total passive income received from all passive income sources (such as other rental properties).
However, the passive activity loss doesn’t go to waste.
As IRS Topic No. 425 Passive Activities explains, an investor can carry forward disallowed or unused passive losses to the next taxable year. For example, if income from the rental property in future years exceeds the annual depreciation expense, any passive activity losses that were carried forward can be used to offset passive activity profits.
Avoid self-employment tax
Income received from a rental property is usually exempt from self-employment tax, also known as FICA or payroll tax.
A self-employed taxpayer is normally required to pay a 15.3% tax for Social Security and Medicare on any income earned. So, if a taxpayer earned $50,000 in self-employment income, the FICA tax due would be $7,650.
However, because income from a rental property is treated as passive income instead of earned income, there is no self-employment tax due. If a real estate investor earned the same $50,000 in income from rental properties, there may be no FICA tax due.
Diversify income and cash flow
Of course, cash flow is one of the main benefits of holding rental property. Aside from the everyday income that you get from a job, diversifying your investment portfolio with a rental property can help improve your financial situation, particularly when assets are held over the long run.
What to watch out for when converting primary residence to rental
Just like there are advantages to converting a primary residence to a rental property, there are also a few important pitfalls that can catch new landlords by surprise. Here are a few things to beware of before venturing down this path.
Success doesn’t happen overnight
As I mentioned earlier, converting a primary residence to a rental property takes time and a good amount of effort. Sure, you can pay a property management company to do many tasks for you, but that may leave you with less net cash flow than expected.
Getting started can be daunting. Where do tenants come from? Who will handle showings of the vacant home? How do you screen tenants properly? Do you hire an attorney to draft a lease? You’ll also need to coordinate the move-in process, routine maintenance inspections, repairs, and capital expenses along the way.
Learn to prepare an annual budget
There are many different variables and expenses that come into play when converting a primary residence into a rental property. Liability and dwelling insurance, ongoing maintenance, property taxes, legal and admin costs, and utilities are just a few that come to mind. It’s a good idea to pull together a rough budget in advance, including the expected monthly rental amount. This is the best way to understand how much cash flow you’re likely to see in your first year as a landlord.
Tax implications if the property is sold
So, we’ve gone over the tax benefits earlier, but let’s touch on one that many future landlords renting out their primary residence do not think about: capital gains tax.
When a primary residence is converted into a rental property, the IRS treats the sale of the property somewhat differently than it would if it were just a primary residence. We’ll go over this a bit more in depth next.
Tax implications of selling primary residence converted to rental
While there are several benefits to converting a primary residence into a rental property, one of the potential drawbacks is taxes that may become due when the rental property is sold.
There are two tax implications that occur when a rental property is sold:
- First, the depreciation expense used to reduce taxable net income is recaptured and taxed as ordinary income, up to a maximum rate of 25%.
- Second, any profits on the sale of the property are taxed using the long-term capital gains tax rate of 0%, 15%, or 20%, depending on an investor’s federal income tax bracket.
Let’s assume a primary residence was converted into a rental property five years ago and is sold today for $325,000. At the time of conversion, the property had a total value of $250,000, including the lot which was valued at $30,000.
Depreciation recapture tax
Over the five years since the primary residence was converted into a rental property, a total depreciation expense of $40,000 was claimed:
- $220,000 basis for depreciation / 27.5 years = $8,000 per year x 5 years = $40,000
Assuming an investor is taxed at the maximum depreciation recapture tax rate of 25%, the tax due on depreciation recapture would be $10,000.
Capital gains tax
The gross profit on the property sold in this example is $75,000, which is calculated by subtracting the sale price of $325,000 from the property value of $250,000 at the time of conversion.
Sellers can deduct closing costs such as real estate commissions, legal fees, transfer taxes, title policy fees, and deed recording fees to lower the profit and the potential capital gains tax owed.
Because the seller in this example listed and sold the rental property on the Roofstock Marketplace, the sales commission was only a 3% commission.
Assuming total tax deductible closing costs were $16,250 (including the sales commission), the amount of profit subject to capital gains tax would be $58,750:
- $75,000 gross profit – $16,260 deductible closing costs = $58,750 profit subject to capital gains tax
If an investor is taxed at the maximum capital gains tax rate of 20%, the capital gains tax due would be $11,750.
One caveat here: If an investor satisfies the “2 out of 5 year rule” they qualify for the home rule exclusion. If you have used a home as your primary residence for two out of the five years preceding the home’s sale, the IRS lets you exempt $250,000 in profit, or $500,000 if married and filing jointly, from capital gains taxes.
Section 1031 Exchange
As we’ve already discussed, one of the drawbacks to converting a primary residence to a rental property is the potential tax impact when the property is sold.
However, rental property owners have the benefit of a Section 1031 exchange to defer paying capital gains tax and depreciation recapture tax. Also known as a tax deferred exchange or simply a 1031, a real estate investor can defer tax by selling one rental property and purchasing another within a certain period of time.
There are a number of rules and restrictions that apply, including the use of a qualified intermediary. Although investors considering a 1031 tax deferred exchange should consult a licensed professional, the process generally works like this:
- Replacement property must be of equal or greater value to the one being sold
- Replacement property must be identified within 45 days
- Replacement property must be purchased within 180 days
One of the benefits of investing in rental property is that multiple 1031 exchanges can be completed over many years or even decades to defer taxes indefinitely.
If an investor eventually decides to sell without finding and closing on a suitable replacement property, any taxes owed will need to be paid. Alternatively, an investor may hold the property and pass it on to his or her heirs. When people inherit real estate, the cost basis is stepped up and any deferred taxes on capital gains and depreciation recapture are eliminated.
Steps to convert primary residence to a rental
While converting a primary residence into a rental property may be a smart decision for some homeowners, it’s important to do things right. Here are six steps to follow before turning a home into a rental:
Pay attention to pros and cons
Pay close attention to how much money you can make by living in the property and renting it out versus not living in the property and renting it out.
Check with HOA
Make sure the homeowners association will allow the home to be used as a rental, because some HOAs have restrictions.
Notify insurance company
Notify your insurance agent or company that the home will be used as a rental property, and discuss any required policy changes. Your existing homeowner policy will typically not cover rental scenarios.
Apply for permits
Apply for any permits and licenses, since some cities and states require a landlord to collect and remit a rental or sales tax.
Prepare home for tenants
Get the home ready to rent by making any needed repairs, figuring out market rent, and marketing the property. When ready be sure to screen prospective tenants, sign a state-compliant lease, and start collecting the rent.
Establish a system to track income and expenses
Understand how to keep track of income and expenses on a rental property, and the tax benefits of owning real estate as an investment.
FAQs on turning primary residence into rental
Here are some of the top questions we’ve received from potential landlords just like you.
What is the cost basis for a primary residence converted to rental property?
Most of the time, the basis is the cost of the property plus any amount paid for capital improvements and any casualty losses that may have been claimed for tax purposes. That said, cost basis is a complicated topic and we recommend speaking with a licensed CPA who can assess your specific situation.
How long do I have to live in my primary residence prior to converting to rental property?
The typical suggestion for living in a primary residence before converting it into a rental property is 12 months, but there is no hard and fast rule from a tax perspective. You should consult a qualified tax professional to assess your risks and opportunities.
Renting out your primary residence right after purchase is not something that people usually do. However, depending on your lender, there may be exceptions.
How do I determine market value when converting a primary residence to a rental?
Typically the value of a property is determined using the lesser of fair market value or the adjusted cost basis on the date of the conversion from primary to rental.
What are the possible tax consequences of converting rental property to primary residence?
We see what you did there. So, just in case things don’t work out when converting your primary residence to a rental, what are the tax implications of reversing it? Great question.
Once the property is converted back to a primary residence, you’ll no longer be able to take those nice tax deductions like the cost of repairs and so on. As it relates to cost basis and capital gains taxes should you then decide to sell the property, you’ll want to talk to a licensed CPA to understand all the potential tax consequences.
Is it time to convert your primary residence to a rental?
There are plenty of potential benefits to converting a primary residence to a rental property, along with possible drawbacks to consider. One of the biggest challenges new real estate investors face is keeping track of income and expenses to claim all of the tax benefits a rental property offers.
Be sure to have a budget together and a system in place to responsibly track all of the expenses associated with your rental.
If you’re looking to reduce the burden of setting up an expense system for your newly converted primary residence, Stessa makes tracking expenses simple. Check out everything our landlord accounting software has to offer before making a final decision on how you’ll track rental income and expenses.
Stessa is built to be flexible enough to handle different income and expense situations, but we do not provide specific tax, legal, or accounting advice. Every investor’s situation is unique and we strongly encourage you to consult with the proper professionals before making any material decisions.