Comedian Brian Regan recounts: I was at the breakfast table this morning and I read in the newspaper that more and more adults are living at home with their parents. That surprised me, I was like “Mom did you read this?!?”
Regardless of what their ever-so-clever children are doing, the somber truth is, more than ever, baby boomers are wanting to downsize their homes. When a taxpayer decides to move to another residence, but find it difficult to sell their present home, or for whatever reason chooses not to do so, they should consider renting out their present home until the market improves or their comedian son is ready to move back in! . Such a decision carries many potential economic risks and rewards, not the least of which are the potential tax benefits and pitfalls.
Taxpayers generally are treated like a regular real estate landlord once they begin renting their home to others. That means they must report rental income on their return, but also are entitled to offsetting landlord-type deductions for the money a taxpayer spends on utilities, operating expenses, and incidental repairs and maintenance (e.g., fixing a leak in the roof). Additionally, they can claim depreciation deductions for the home, and fully offset their rental income with otherwise allowable landlord-type deductions. However, under the tax laws, passive activity loss (PAL) rules, taxpayers may not be able to currently deduct the rent-related deductions that exceed rental income unless an exception applies. Under the most widely applicable exception, the PAL restrictions won’t affect converted property for a tax year in which a taxpayer’s adjusted gross income doesn’t exceed $100,000, a taxpayer actively participate in running the home-rental business, and losses from all rental real estate activities in which a taxpayer actively participate doesn’t exceed $25,000.
Landlords should also be aware that potential tax pitfalls may arise from the rental of their residence. Unless the rentals are strictly temporary and are made necessary by adverse market conditions, a taxpayer could forfeit an important tax break for home sellers if a taxpayer finally sells the home at a profit. In general, a taxpayer can escape taxation on up to $250,000 ($500,000 for certain married couples filing joint returns) of gain on the sale of their home. However, this tax-free treatment is conditioned on their having used the residence as their principal residence for at least two of the five years preceding the sale. So renting a home out for an extended time could jeopardize a big tax break. Even if a taxpayer doesn’t rent out their home so long as to jeopardize their principal residence exclusion, the tax break a taxpayer would have gotten on the sale (i.e., exclusion of gain up to the $250,000/$500,000 limits) will not apply to the extent of any depreciation allowable with respect to the rental or business use of the home for periods after May 6, 1997, or to any gain allocable to a period of nonqualified use (i.e., any period during which the property is not used as the principal residence of the taxpayer or the taxpayer’s spouse or a former spouse, such as a rental) after Dec. 31, 2008. A maximum tax rate of 25% applies to this gain (attributable to depreciation deductions).
Some homeowners who bought at the height of a market may ultimately sell at a loss. In such situations, the loss is available for tax purposes only if the owner can establish that the home was in fact converted permanently into income-producing property, and isn’t merely renting it temporarily until he can sell. Here, a longer lease period helps an owner. However, if a taxpayer is in this situation, a taxpayer should be aware that a taxpayer probably won’t wind up with much of a loss for tax purposes. That’s because basis (cost for tax purposes) is equal to the lesser of actual cost or the property’s fair market value when it’s converted to rental property. So if a home was bought for $300,000, converted to rental property when it’s worth $250,000, and ultimately sold for $225,000, the loss would be only $25,000.
The question of whether to turn a principal residence into rental property isn’t easy to resolve. At Isler CPA we can review your situation in detail and guide a taxpayer to an answer that makes the most sense for you. I recommend that we sit down and review together how a rental decision will affect your income and deductions, and tax breaks as a home seller.