by Bob Rywick
There may be several reasons why a client who is planning to move into a new principal residence is considering renting his present home instead of selling it.
For example, the client may believe that the value of the home will grow substantially over the next couple of years, and wants to benefit from that increase before selling it. There are both potential tax benefits and pitfalls that you should discuss with a client who is considering whether to sell his principal residence or convert it to rental property.
Income tax effect of converting principal residence into rental property. An individual who converts a principal residence into rental property must report rental income on Schedule E of her Form 1040. The taxable income from rental real property can be reduced by deductions for expenses such as insurance, cleaning and maintenance, utilities (e.g., gas, oil, water), legal and professional fees, advertising, repairs and maintenance, supplies, and depreciation.
Items such as real estate taxes and mortgage interest that could be taken only as itemized deductions when the property was used as a principal residence can be taken as above-the-line deductions in computing adjusted gross income when taken with respect to rental property.
Hopefully, your client’s rental income will exceed deductions. If they don’t, he may be able to use the excess of deductions over income to offset income from other sources. However, the passive activity loss rules may limit his ability to currently deduct the excess of rent-related deductions over rental income unless an exception applies.
Under the most widely applicable exception, the passive-activity loss rules won’t affect an individual’s ability to deduct the excess losses for a particular tax year if:
● His modified adjusted gross income doesn’t exceed $100,000;
● He actively participates in running the rental business; and,
● His losses from all rental real estate activities in which he actively participates don’t exceed $25,000.
If modified AGI is more than $100,000, then the deductible loss is reduced by 50 percent of the excess of modified AGI over $100,000. Thus, if the loss were $25,000, it would be completely phased out if modified AGI were $150,000 or more. Passive-activity losses are not taken into account in computing modified AGI.
Example 1: Your client, who is single, plans to buy a new home and move into it on July 1, 2003. Instead of selling his current principal residence, which he values at about $400,000, he plans to rent it for two years and then sell it.
He paid $250,000 for the house, and he has owned it and lived in it for over three years. Thus, he would be eligible for the homesale exclusion on the full gain if he sells it no more than three years after he stops using it as his principal residence. The exclusion would apply even to the increase in value after he stops using it as his principal residence. The only gain that would be taxed would be the part of the gain attributable to depreciation taken on the house after he starts renting it out.
He expects to actively participate in renting the house, and for the second half of 2003 (the first year it is rented), he expects to have a $10,000 loss after taking a depreciation deduction of about $3,500 ($7,000 for the full year) and making necessary repairs. He will have no other losses from rental real property and will have no other passive activity income or losses in 2003. If his modified AGI is less than $100,000, he will be able to deduct the entire $10,000 loss in computing his taxable income.
But if his modified AGI is $120,000 or more, he will not be able to deduct part of the loss. If his modified AGI is $110,000, he will be able to deduct half of the loss, or $5,000.
Recommendation: A client who is considering converting a principal residence to rental property should consider delaying making repairs until after the conversion so he can deduct the cost of the repairs in computing his taxable income (or loss) from the property.
Don’t forget the homesale exclusion. Unless your client plans to sell the property no more than three years after it is converted to a rental property, he would lose the $250,000 ($500,000 for a married couple filing a joint return) exclusion when the property is sold.
If the property is sold more than three years after he stopped using it as a principal residence, then the exclusion won’t apply because it wasn’t used as the principal residence for two of the five years before the sale. Thus, renting a former principal residence for an extended time could jeopardize a big tax break.
Example 2: Your clients, a married couple, owned and used a house as their principal residence for over two years for the period ending April 30, 2003, when they moved into a new principal residence. Their basis in their former residence was $200,000 and they estimate they could sell it for $650,000.
Instead of selling it, however, they rented the house out starting on June 1, 2003, for a term of 36 months ending on May 31, 2006. If they do not sell the house before the lease expires, they will lose the benefit of the homesale exclusion (up to $500,000 in their case), and will have to pay a capital gains tax on all of their gain.
Thus, if they sell the house in June 2006 for a net price of $650,000, they will have a capital gain of $450,000 plus the amount of depreciation they took on the house during the period it was rented.
If the total depreciation taken was $15,000, their total gain on the sale would be $465,000, $450,000 of it taxable at a maximum rate of 20 percent and $15,000 taxable at a maximum rate of 25 percent. Thus, their federal income taxes on their gain could be as much as $93,750. State taxes on the capital gain might also have to be paid. It’s unlikely that they could rent the house out for enough to make up for the additional taxes that they would have to pay on the sale.
Observation: As I’m writing this article, Congress is considering reducing the maximum tax on capital gains to 15 percent. Even at that lower rate, your clients would usually want to make sure that they don’t lose the homesale exclusion.
Observation: Presumably, in Example 2, your clients could sell their house before the lease expired by selling it subject to the tenancy of the lessee. However, some potential buyers might insist on the premises being vacant at the time that the property is deeded to them, so your clients might have to make some payment to the lessee to get an early termination of the lease.
Elderly clients may benefit from converting a principal residence into rental property even if the homesale exclusion is lost.
In some situations, however, the excess of the value of an individual’s principal residence over his basis in the residence may be far more than the allowable homesale exclusion. This is most likely to happen in the case of an elderly individual who bought the principal residence many years ago. Such an individual may prefer to rent out the residence for the balance of his life so that his heirs will get a step up in basis when he dies.
Example 3: Your client is an elderly widow who is 80 years old and has three adult children. Her husband died over 30 years ago. She currently owns a house that she has used as her principal residence for over 50 years. The value of the house is about $700,000 and her basis in it is only $100,000 (including a partial step-up in basis when her husband died).
She plans to move into an assisted care facility in a few months. If she sells the house, she will have a total gain of $600,000 on the sale, $350,000 of which will be taxable ($600,000 less homesale exclusion of $250,000).
She has been told that she can rent it out for $4,000 a month ($48,000 a year). Her net yearly rental after expenses other than depreciation will be about $35,000 a year. That amount plus her Social Security benefits and her pension as a schoolteacher will allow her to pay the costs of the assisted care facility.
When she dies, the basis in the house will be stepped up to its fair market value at the time of her death, and no taxes will have to be paid on the capital gains when her heirs (her three children) sell. This will be so even if the value of the house continues to appreciate substantially before she dies.
Observation: Even if the estate tax is repealed before your client in Example 2 dies, her estate will still be able to get a step up in basis for the house since her estate will still be able to add up to $1.3 million dollars to the original basis of her assets. However, the basis of any asset can’t be increased above its fair market value.
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