Tax Issues When Converting a Home to a Rental

Posted by Lee Reams Sr. on

When a taxpayer converts their home to a rental, there are a number of tax issues that come into play.  The following are key tax circumstances that should be considered before making the decision to convert.

Home Sale Gain Exclusion – When an individual has owned and occupied a home for 2 of the prior 5 years as their primary residence, tax law allows the individual to exclude up to $250,000 of gain from the sale of the home.  In the case of a married couple, that exclusion is doubled to $500,000 if one of them owns the home for 2 out of the 5 prior years and both spouses meet the 2-out-of-5-year occupancy requirement.  Therefore, if the home is converted to a rental and after three years or more has passed the property is sold, the individual(s) will no longer qualify for the home gain exclusion, something that should be carefully considered in advance of any conversion (Sec 121).

Should the home be rented and sold before the gain exclusion expires, even though the exclusion may still apply, any gain to the extent of the depreciation taken on the home cannot be excluded (Reg. §1.121-1(c)(4)).

Home Sale Loss Rule – If an individual sells his or her personal residence and sustains a loss, that loss is not deductible because it is from personal use property for which losses are not tax deductible (Reg § 1.165-9(a)).  However, if an individual sells a rental at a loss, the loss is tax deductible in the year of sale. To prevent a homeowner from converting their home to a rental in an attempt to convert a nondeductible personal loss into a deductible business loss, the IRS requires the business basis of the converted home to be the lesser of the home’s adjusted cost basis or the home’s fair market value at the time the property is converted to a rental.

Where the FMV of the home is less than the home’s adjusted cost basis, this could create two bases, one for determining a loss, the business basis, and one for determining a gain, the adjusted cost basis, when the rental is subsequently sold. So, attempting to convert a home to a rental in order to deduct a loss from personal use will not work.

Interest Deductions – An individual can deduct the interest on up to $1 Million of mortgage acquisition debt, which is debt used to purchase or substantially improve the individual’s primary home and second home.  In addition, a taxpayer can deduct the interest on up to $100,000 of home equity debt.  For rental property, the only interest that can be deducted is the interest on acquisition debt.

It is quite common for a homeowner to use the equity in their home to buy cars, fund education, pay for vacations and other uses. Where there is equity debt on a home that is converted to a rental, the interest on the equity debt is no longer deductible.  This is yet another issue that must be considered when deciding whether to convert a home to a rental property.