Although many people choose to sell their home before buying another one, that isn’t necessarily the right choice for everyone.
The demand for single-family rental property in many markets is reaching all time highs, and rents are growing by double-digits in many cities across the country. For some homeowners, it may make more financial sense to turn an existing home into a rental, then buy another home to live in.
In this article, we’ll discuss potential benefits of converting a primary residence to a rental property, how taxes work, and key steps to follow before becoming a landlord.
- 4 potential benefits of converting a home to a rental are tax deductions, rental income, depreciation expense, and tax loss carryforwards.
- One of the drawbacks to owning a rental property is paying capital gain tax when the property is sold, although investors may benefit by performing a tax deferred exchange.
- 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 insurance, getting the home ready to rent, and having rental property software to track income and expenses.
Benefits of converting a primary residence to a rental property
A lot of things change when a primary residence is converted into a rental property, and most of the changes are good. Here are four of the biggest benefits of owning a rental property along with an explanation of how they work.
Income from a 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.
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 income would be $6,000.
Another benefit of turning a primary residence into a rental is being able to depreciate the property 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 is the purchase price of the home plus qualified improvements (such as a new roof or adding additional square footage) or 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 PAL 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), unless an investor’s adjusted gross income is less than $100,000.
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 would be no FICA tax due.
Tax impact of selling a home that was converted to a rental property
While there are several benefits to converting a personal residence into a rental property, one of the potential drawbacks is taxes when the rental property is sold.
An owner of a primary residence can exclude up to $250,000 of any sales gains from taxation, or up to $500,000 in gains if married filing jointly. Capital gains on rental property works differently.
There are two tax impacts 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.
To illustrate, 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 investors have owned the property for at least 5 years, they can avoid capital gains taxes by selling within 2 years of turning the property into a rental.
How to defer tax when a rental property is sold
One of the drawbacks to converting a primary residence to a rental property is the 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 a 1031 can be conducted an unlimited number of times.
If an investor eventually decides to sell without replacing the property, any taxes owed will need to be paid. Or, an investor may hold the property and pass it 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.
8 steps to complete before turning a home into a rental
While turning a primary residence into a rental property may be a smart decision for some homeowners, it’s important to do things right. Here are eight steps to follow before turning a home into a rental:
- Consider the potential pros and cons, such as generating rental income and claiming tax deductions versus having to be a landlord and and manage the property.
- Check with the lender to see if the existing mortgage can be used for a rental property instead of a primary residence.
- Research options for investment property loans if the home will need to be refinanced as a rental property.
- Make sure the homeowners association will allow the home to be used as a rental, because some HOAs have restrictions.
- Notify your insurance agent that the home will be used as a rental property, and discuss adding landlord liability insurance to the homeowners insurance policy.
- Apply for any permits and licenses, since some cities and states require a landlord to collect and remit a rental or sales tax.
- Get the home ready to rent by making any needed repairs, setting a fair market rent, marketing the property and screening tenants, and signing a lease and collecting the rent.
- Understand how to keep track of income and expenses on a rental property, and the tax benefits of owning real estate as an investment.
Final thoughts on this topic
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.
Stessa was designed by fellow real estate investors to help both novice and sophisticated investors make tracking real estate investments simple.
After signing up for a free Stessa account, investors can automatically track income and expenses, collect rent online, keep track of depreciation on the real estate balance sheet, generate income and cash flow statements, and export tax-ready financials when tax time comes around.