Scenario: You have decided to move to another residence, but are finding
it difficult to sell your present home. Then… the light bulb comes on
-- you'll rent the old home for a while until the market turns around or
until you are more serious about selling. If you're thinking of taking this
step, you no doubt are fully aware of the economic risks and rewards. However,
you should also be aware that renting out your personal residence carries
potential tax benefits AND tax pitfalls.
You are generally treated like a regular real estate landlord once you begin
renting your home to others. That means you must report rental income on
your tax return. But it also means that you 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 passive activity loss (PAL) rules, you may not be able
to deduct your net rental expenses unless an exception to the PAL rules applies.
Under the most common PAL exception, the net rental expenses on your converted
property will be allowed if:
1. Your adjusted gross income (AGI) does NOT exceed $100,000; and 2. You
actively participate in running the home-rental business; and 3. Your losses
from all rental real estate activities in which you actively participate
don't exceed $25,000.
Example 1: You converted your principal residence to a rental unit
in 1997. You compute your rental income and expenses (including depreciation)
on Schedule E, and determine that you have a rental loss of $3,500. You actively
participate in the running of the rental property (you set the rents, make
the decisions regarding repairs, etc.). You also determine that your 1997
AGI, without regard to the rental loss, amounts to less than $100,000. You
will be able to deduct your entire rental loss on your 1997 tax return.
Example 2: Start with the same facts as above, but assume that your
AGI is greater than $150,000. In this case, your rental losses would be suspended
and would not be deductible on your 1997 tax return. It is suspended and
carried forward to a following year when you have passive income and/or you
dispose of the property.
Generally, if your AGI is greater than $100,000 but less than $150,000 (the
phase out range), some of your rental losses may be deductible and some may
not. But you'll have to complete IRS Form 8582 and the associated worksheets
in order to determine the amount of your rental loss deductions. Once your
AGI exceeds $150,000, your rental losses will normally be suspended in total,
and you will not receive any current rental loss deductions. The purpose
of this article is not to discuss the rental loss limitations, but you should
be aware that they can be very complicated. For additional information regarding
the passive loss rules and how they apply to rental activities, read IRS
Publication 925 at the IRS website
(http://www.irs.ustreas.gov/forms_pubs/pubs.html).
So much for the good news. You also need to be aware that there are a number
of potential tax pitfalls that 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 homesellers
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. (For additional information on the details
of this tax provision, please read my prior article entitled
"Home Sale
Tax Exclusions".
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 for an extended period
of time, the IRS may still consider the prior residence a rental unit (with
the gain fully taxable) on the date of the sale… which could also cost
you're your gain exclusion. Finally, even if you can overcome both of the
above hurdles, any depreciation allowable with respect to the rental use
of the home for periods after May 6, 1997, will be subject to recapture tax
at a maximum rate of 25%, and this recapture tax will be due on the depreciation
even if the remainder of the gain can be excluded.
Now, perhaps you REALLY want to convert the home into a rental. You are thinking
that, since you bought the home at the top of the market, you'll convert
it to a rental unit, sell the property at a large loss in the future, and
deduct the entire loss. While this shows some good thinking on your part,
the IRS already thought of it and has closed this loophole. When you run
the numbers, you'll find that you really won't have much of a loss. Why?
Because your basis (or cost, for tax purposes) is equal to the lesser of
actual cost or the property's fair market value (FMV) when it's converted
to rental property.
Example: You originally bought your home at the top of the market
for $200,000. It is now worth $110,000. You want to convert it to a rental
property and then sell it for a large loss in the future. Your basis for
depreciation (and gain or loss on any subsequent sale) would be the LESSER
of your original $200,000 purchase price OR the FMV at the date of the
conversion. In this example, your basis for tax purposes would amount to
the FMV of $110,000. This being the case, the $90,000 that you are trying
to take as a tax loss will never be recognized as such, will be considered
a non-deductible personal loss, and will never be a tax deduction or loss
for you.
The question of whether to turn a principal residence into rental property
isn't easy to resolve. Before you make your decision, make sure that you
know ALL of the economic factors AND tax factors. And if you are unsure about
the impact of your decision, make sure to retain the services of a qualified
tax pro to review your specific circumstances and help you with your decision.
- 03/19/98
