Converting Your Home to a Rental
By: Renee Daggett
Sometimes there are economic reasons why people convert their personal residence to
a rental. Maybe they are not able to sell the home. Or, their family has been downsized
due to kids leaving or a divorce. Or, maybe health or financial reasons will motivate this
change.
First, you have to determine whether the home is a rental for
profit, a vacation rental or a rental not engaged in for profit.
A rental is considered “not for profit” when rented at less than
Fair Rental Value, possible to a family member. In these
cases, income is reported as “other income” on line 21 of the
Form 1040. Expenses are allowed, but limited to rental
income collected and claimed on Schedule A, under
miscellaneous deductions, subject to 2% AGI.
The term vacation rental refers to the taxpayer’s personal use of the property. Days
that the house is rented at less than the fair rental value count as personal use days. If
a taxpayer has no personal use, the property is treated as a rental. All income and
expenses are reported on Schedule E.
If the property is rented for 14 days or less, there is a minimal use exception. The rental
income is not reported and all interest and property taxes are deducted on Schedule A.
If the property is rented more than the greater of 14 days or 10% of the number of days
rented at fair rental value, the rental income is reported on Schedule E. The mortgage
interest and property taxes are allocated between Schedule E and Schedule A based
on the number of days rented. For example, if Joe rented his home for 91 days and
used it personally for 30 days, the mortgage interest would be 91/365 = 24.93% on
Schedule E and the balance of interest on Schedule A. For operational expenses, the
percentage on Schedule E would be 91/121 (91 + 30). Operational expenses related to
personal use are not deductible.
You will need to determine the basis for depreciating the rental, if for profit. To do this,
first establish the adjusted basis. This is the original cost plus improvements minus any
insurance reimbursements or tax credits. Then, establish the fair market value at the
time the home was placed in service for rent. This can be done by comparable sales,
appraisal or try www.zillow.com. Then, when you compare the adjusted basis with the
FMV, you always take the lower number to use for depreciation.
As with any rental, there are loss limitations of $25,000 for single and married filing joint
taxpayers. And, if your income is over $100,000 you may not get all the losses. If your
income is over $150,000, your losses will be suspended and you will be able to use
them either when you have rental profits or you sell the rental property.
When you sell a property that was your personal residence, you
have to use the adjusted basis, if there is a gain or the fair market
value basis if there is a loss on the property. Also, look back on
the last 5 years of the rental. If the house was used for at least two
out of the last five years as a principal residence, then the taxpayer
can use the Section 121 exclusion to exclude up to $250,000 of
gain on the sale ($500,000 of gain for married filing jointly). If you
wait too long to sell the property so that the time you used it as a
primary home was more than 5 years, you will not be able to
exclude the gain. However, you cannot exclude the part of the
gain equal to the depreciation claimed while renting the house.
In contrast, if you convert a vacation or rental property to a principal residence the
amount of section 121 gain that can be excluded on sale must be adjusted for the time
you did not use it as a primary home. This applies to use of the home in 2009 or later.
Exceptions apply to military and foreign service.
To calculate the amount of the gain not eligible for the exclusion, you have to calculate
the gain times the number of days of nonqualified use divided by the number of days
owned.
Recordkeeping of dates will be key!
The decision to convert a primary home to a rental should not be made in haste. As
you can see, there are many details and responsibilities that go along with the
conversion.
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