Here’s a scenario: Let’s say you’re moving out of your current home. Maybe to downsize, maybe to someplace with better weather, whatever. Given that real estate seems like a pretty good inflation hedge, you might be reluctant to sell your soon-to-be former abode. Rents rose 9% year-over-year in September — the first single-digit increase in 12 months, and a slowdown from 18% growth in March, according to the latest data from Redfin
So, should you convert your place into an income-producing rental property instead of selling? Maybe. Here are the federal income tax plusses and minuses to consider.
What you can write off for a rental property
You can deduct mortgage interest and real estate taxes on a rental property.
You can also write off all the standard operating expenses that go along with owning a rental property: utilities, insurance, repairs and maintenance, yard care, association fees, and so forth.
Finally, you can also depreciate the tax basis of a residential building (not the land) over 27.5 years using the straight-line method, even while it is (you hope) continuing to increase in value. The property’s initial tax basis for depreciation purposes usually equals the original purchase price, minus the purchase price allocable to the land, plus the cost of improvements, minus any depreciation write-offs that you’ve claimed over the years (say from having a deductible office in the home).
Depreciation deductions are great because they can shelter some or all of your cash flow from the federal income tax. For instance, say the basis of your property (not including the land) is $500,000. Your annual depreciation deduction is $18,182 ($500,000/27.5). Basically, you can have that much annual positive rental cash flow without owing anything to Uncle Sam. Nice.
But…passive loss rules can suspend rental tax losses
If your rental property throws off a tax loss, things can get complicated. The dreaded passive activity loss (PAL) rules will usually apply. In general, the PAL rules only allow you to deduct passive rental losses to the extent you have passive income from other sources — like positive income from other rental properties or gains from selling them. Passive losses in excess of passive income are suspended until you either have more passive income or you sell the property or properties that produced the losses.
Bottom line: the PAL rules can postpone rental property loss deductions, sometimes for many years. Fortunately, there are exceptions to the PAL rules that can allow you to deduct losses sooner rather than later. See the SIDEBAR below.
What if I have positive taxable income from my rental?
Sooner or later, your rental property will probably throw off positive taxable income, because escalating rents will surpass your deductible expenses. In today’s rental market, you may have positive taxable income on Day One. Of course, you must pay income taxes on rental profits. But if you piled up suspended passive losses in earlier years, you now get to use them to offset your passive profits.
Another caveat: positive passive income from rental real estate can get socked with the 3.8% net investment income tax (NIIT), and gains from selling a rental property can also get hit with the NIIT. However, the NIIT only hits upper-income folks. Consult your tax adviser for details.
Taxpayer-friendly rules when you sell
I hope you’ll eventually sell your converted property for a tidy profit. If so, you’ll have a tax gain to the extent the net sale price exceeds your tax basis in the property after adding the cost of any improvements and subtracting depreciation deductions, including depreciation claimed after you converted the property into a rental.
But…gain exclusion deal may still be available
If you sell your former principal residence within three years after converting it into a rental, the federal home sale gain exclusion break will usually be available. Under that deal, you can shelter up to $250,000 of otherwise-taxable gain or up to $500,000 if you’re married. However, you cannot shelter gain attributable to depreciation, including depreciation claimed after you converted the property into a rental.
Tax results with no gain exclusion
When you sell a rental property that you’ve owned for more than one year and the gain exclusion deal is unavailable because you’ve rented it for too long, the taxable gain (the difference between the net sales proceeds and the tax basis of the property after subtracting depreciation deductions claimed during the rental period) is generally treated as a long-term capital gain. As such, it’s taxed, under today’s rules, at a federal rate of no more than 20%, or 23.8% if you owe the 3.8% NIIT. However, part of the gain — an amount equal to the cumulative depreciation deductions claimed for the property — is subject to a 25% federal rate, or 28.8% if you owe the 3.8% NIIT. The rest of your gain will be taxed at a maximum federal rate of no more than 20% (or 23.8%). Don’t forget that you may also owe state and local income taxes on real estate gains.
Key point: When evaluating converting an appreciated home into a rental property, keep in mind that you will eventually lose the gain exclusion privilege, which is one of the most valuable tax breaks on the books. Giving it up should not be taken lightly.
Key point: Remember those suspended passive losses we talked about earlier? You can use them to shelter otherwise-taxable gains from selling an appreciated rental property.
Section 1031 exchange can defer tax hit from selling
The federal income tax law allows rental real estate owners to unload appreciated properties while deferring the federal income hit indefinitely. Here we are talking about Section 1031 exchanges (named after the applicable section of our beloved Internal Revenue Code).
With a 1031 exchange, you swap the property you want to unload for another property (the replacement property). You’re allowed to put off paying taxes until you sell the replacement property. Or when you’re ready to unload the replacement property, you can arrange yet another 1031 exchange and continue deferring taxes.
While you cannot cash in your real estate investments by making 1031 exchanges, you can trade holdings in one area for properties in more-promising locations. In fact, the 1031 exchange rules give you tons of flexibility when selecting replacement properties. For example, you could swap an expensive single-family rental house for a small apartment building, an interest in a strip shopping center, or even raw land.
For details on Section 1031 exchanges, see this recent Tax Guy column.
The bottom line
Converting a personal residence into a rental property can trigger some potentially tricky tax rules. But if the place is throwing off positive cash flow and appreciating, that’s just a cost of doing business.
SIDEBAR: Three favorable exceptions to the PAL rules
Exception No. 1: for ‘active’ rental property owners
This is the most widely-available exception. It says you can deduct up to $25,000 of rental property PALs if: (1) your modified adjusted gross income (MAGI) is no more than $100,000 and (2) you actively participate in the property. Active participation means at least making property management decisions like approving tenants, signing leases, authorizing repairs, and so forth. You don’t have to mow lawns or snake out drains to pass the active participation test.
If your MAGI is between $100,000 and $150,000, the exception is phased out pro-rata. For example, say your MAGI is $125,000. You can deduct up to $12,500 of PALs from rental properties in which you actively participate (half $25,000 maximum). If your MAGI exceeds $150,000, you’re completely ineligible for the active participation exception.
Exception No. 2: for ‘real estate pros’
This exception is only available to folks who we will call real estate professionals. To be eligible, you must spend over 750 hours during the year in real estate activities (including non-rental activities such as acting as a realtor or real estate broker) in which you materially participate. In addition, the hours you spend on real estate activities in which you materially participate must exceed 50% of all the time you spend working in personal service activities. If you clear these hurdles, losses from rental properties in which you materially participate are exempt from the PAL rules, and you can generally deduct the losses in the year they are incurred.
Meeting the material participation standard is harder than passing the Exception No. 1 active participation test. The three easiest ways to meet the material participation standard for a rental property are by:
1. Making sure the time you spend on the property during the year constitutes substantially all the time spent by all individuals (including non-owners).
2. Spending more than 100 hours on the property and making sure no other individual spends more time than you.
3. Spending over 500 hours on the property.
Exception No. 3: For short-term rentals
Say you decide to rent out your property on a short-term basis through Airbnb or VRBO. If the average rental period for your property is seven days or less, you can avoid the PAL rules by materially participating in the property, as explained immediately above. Then you can generally deduct rental losses from the property in the year they are incurred.