Converting Residence to Rental: Critical Considerations

When you choose to change your primary residence, or decide that you no longer need your vacation home, the usual course of action is to sell the property. However, if you do not want to or cannot sell the property, leasing the property may be an alternative solution to consider.

Leasing allows your tenant to pay for the yearly costs of ownership, and may even provide helpful monthly cash flow. Becoming a landlord, however, is a larger undertaking than most people realize, so it’s important to consider the full impact. Although the business challenges of finding the right tenant and managing payment terms can be onerous, it is the tax implications which can make or break your decision. The calculation of yearly taxable income and the taxable gain or loss if you decide to sell the property in the future are the two areas you must consider.

The calculation of yearly taxable income from the rental of your property is not as easy as simply reviewing bank or credit card statements to calculate total rental receipts received and direct expenses paid. In the initial year, the timing of certain expenses and calculation of basis for depreciation require more thought and attention. One factor is the timing of repairs (i.e., painting, power washing, etc.) that need to be done before the property can be offered for rent. These repairs only reduce taxable income if they are incurred after you converted the property to rental use (meaning that you are no longer living or using the property personally). As such, these expenses should be delayed until you move out or stop using the property.

Depreciation is the expensing of the original purchase price over a specific number of years.  Although it sounds uncomplicated, there is one big caveat: If your property has decreased in value over your ownership period and the fair market value (FMV) of the property is less than your total cost (acquisition plus any renovation costs), you will have to take the FMV in lieu of taking the cost over the allowable depreciation period (usually 27.5 years). The following table illustrates the potential scenarios:

The potential gain if you decide to sell the property in the future should be considered before you begin renting your property. There is an exclusion of up to $250,000 ($500,000 for married couples) of gain associated with the sale of your personal residence, provided that you lived in the property for at least two years of the five years immediately before the date of sale (note: There are additional rules and restrictions that are outside the scope of this article). If your property has increased in value during your ownership period and you elect to sell the property five years after you began renting it, you would not be able to exclude any gain and could be paying tax on $500,000 of otherwise excludable income.

The rules for calculating the gain on the later sale of the rental property are pretty straightforward if at the time you began renting the property, the FMV was greater than the original cost of the property. In this situation, the gain or loss is calculated as sales price less cost of sale and adjusted cost basis (cost basis less depreciation taken to date). The complexity comes when, at the time of conversion, the FMV is less than the cost basis and you are selling the property at a loss. The loss in this situation is calculated as the sales price less FMV at time of conversion plus depreciation taken to date.

When deciding to convert your residence or vacation home to a rental property, make sure you consider all of the tax implications to make the choice that best suits your personal financial goals.