Tax Insights: Converting your Primary Residence to a Rental

Sometimes it never rains but it pours. As a tax lawyer who meets with many people during the week, I’ll go an entire year without advising on a concept but then suddenly, I’ll talk about it several times in one week. This past month, exactly that happened – I found myself talking to prospective clients who wanted to convert their primary residence to a rental. So why not double down and explore it here as well?

Converting to a rental is a pretty simple maneuver that brings with it many tax rules. Most are beneficial when you know how they work, and you plan ahead.

Tax Basis

The first question that arises when you convert a personal residence into a rental is how to determine the property’s tax basis for depreciation purposes during the rental period and for gain/loss purposes when you eventually sell.

Oddly enough, two different basis rules apply:

1. If, after conversion to a rental, you sell at a gain, your basis on the conversion date is the usual computed amount (cost of home plus improvements, minus depreciation).
2. If, after conversion to a rental, you sell at a loss, your basis on the conversion date is the lesser of the computed basis or the fair market value.

Deductions

Once you’ve converted a former personal residence into a rental, you can now deduct expenses. Here is a quick summary of the most important things to know:

• 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 cost of a residential building over 27.5 years, even while it is (you hope) increasing in value.

Passive Income/Loss

According to the tax code, real estate is a per se passive activity. Unless you are a real estate professional (as the Code defines the term), if your rental property throwing off a tax loss can complicate things.

The so-called passive activity loss (PAL) rules will usually apply. In general, the PAL rules allow you to deduct passive losses only to the extent you have passive income from other sources, such as positive income from other rental properties or gains from selling them.

Eventually, your rental property should start throwing off positive taxable income instead of losses, because escalating rents will surpass your deductible expenses. Of course, you must pay income taxes on those profits. But if you piled up suspended passive losses in earlier years, you now get to use them to offset your passive profits.

Another nice thing: positive taxable income from rental real estate is not hit with the dreaded self-employment (SE) tax, which applies to most other unincorporated profit-making ventures. The SE tax rate can be up to 15.3 percent, so it’s a wonderful thing when you don’t have to pay it.

Always keep in mind the good news here. You don’t pay the taxes on the property appreciation until you sell. And you could always consider a 1031 exchange.

What is the downside?

Many practitioners do not warn their clients about the downside of converting a primary residence to a rental. And it involves long term capital gain.

The greatest advantage of owning a primary residence is the long term capital gain exclusion on a primary residence.  Married couples in 2023 can exclude $500,000 of capital gain on the sale of their primary residence if they lived in the house for 2 out of the last 5 years.

That’s a huge benefit – that’s an amazing amount of income that doesn’t get taxed.

Let’s run two examples:

Assume Alice and Bob buy their house for $535,000 and over the course of owning it make about $35,000 of improvements. Seven years later, they sell the house for $800,000 and buy a rental with the proceeds while keeping a small amount for a downpayment on a new house.

A&B sell and buy a rental

Purchase price:            $535,000

Improvements:            $35,000

FMV at sale:                $800,000

Gain not taxed:           $230,000

Tax:                             $0

A&B sell their house and never pay tax on $230,000.

Now, assume Cathy and Dave do exactly the same, but they convert the property into a rental instead and sell outside the 5-year window to qualify for the capital gain exclusion:

C&D – convert and sell rental later

Purchase Price:            $535,000

Improvements:            $35,000

FMV at sale:                $800,000

Taxable gain:              $230,000

Tax (at 15%):              $34,500

Now what would you do with an extra $34,500? I’m sure we can all think of something we’d rather do than give it to Uncle Sam. Granted, to keep it simple I’ve left out depreciation, but you get my point.

The other advantage that Alice and Bob have over Cathy and Dave is that they don’t have to do a 1031 exchange to avoid tax. They immediately reap the benefits. Instead, for Cathy and Dave, the most powerful exit strategy open to them is to avoid tax with a 1031 exchange. This isn’t quite as good because it just kicks the problem further down the road.  The only way they can have the same outcome as Alice and Bob (i.e., not ever paying tax on the gain) is to die and give their children a stepped-up basis.

Thoughts

Lots of moving parts to every scenario and a good tax advisor is necessary to understand what you might be leaving on the table. At Fusion, we pride ourselves on our tax plans and our ability to do a deep dive to find the bigger picture and ensure that no opportunity is left unexplored.