Converting Your Home Into a Rental Property: Tax Issues

The simple maneuver of converting your personal residence to a rental property brings with it many tax rules, mostly good when you know how they work.

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The first question that arises when you convert a personal residence into a rental is how to determine the property’s tax basis for depreciation purposes during the rental period and for gain/loss purposes when you eventually sell.

Oddly enough, two different basis rules apply:

If, after conversion to a rental, you sell at a gain, your basis on the conversion date is the usual computed amount (cost of home plus improvements, minus depreciation—such as from a home office).

If, after conversion to a rental, you sell at a loss, your basis on the conversion date is the lesser of the computed basis or the fair market value.

Once you’ve converted a former personal residence into a rental, you must follow the tax rules for landlords. Here is a quick summary of the most important things to know:

You can deduct mortgage interest and real estate taxes on a rental property.

You can also write off all the standard operating expenses that go along with owning a rental property: utilities, insurance, repairs and maintenance, yard care, association fees, and so forth.

Finally, you can also depreciate the cost of a residential building over 27.5 years, even while it is (you hope) increasing in value.

Rental Real Estate Losses
If your rental property throws off a tax loss, things can get complicated.

The so-called passive activity loss (PAL) rules will usually apply. In general, the PAL rules allow you to deduct passive losses only to the extent you have passive income from other sources, such as positive income from other rental properties or gains from selling them.

Eventually your rental property should start throwing off positive taxable income instead of losses, because escalating rents will surpass your deductible expenses. Of course, you must pay income taxes on those profits. But if you piled up suspended passive losses in earlier years, you now get to use them to offset your passive profits.

Prior Losses Can Offset Future Positive Income
Another nice thing: positive taxable income from rental real estate is not hit with the dreaded self-employment (SE) tax, which applies to most other unincorporated profit-making ventures. The SE tax rate can be up to 15.3 percent, so it’s a wonderful thing when you don’t have to pay it.

One other good thing is that your net rental profits may qualify for the Section 199A deduction.

Another good thing is that if your rental property rises to the level of a trade or business, your rental profits avoid getting socked with the 3.8 percent net investment income tax (NIIT).

Taxes When Selling Rental Real Estate
When you sell a rental property that you’ve owned for more than one year, the profit (the difference between the net sales proceeds and the tax basis of the property after subtracting depreciation deductions during the rental period) is generally treated as a long-term capital gain.

Always keep in mind the good news here. You don’t pay the taxes on the property appreciation until you sell.

Remember those suspended passive losses we mentioned above? The suspended losses are ordinary losses. When you sell a rental, you can find two great benefits:

Gains are tax-favored capital gains.

And then, to the extent of your gains, you release suspected passive losses that offset ordinary income.

Avoid Paying Taxes on Real Estate Capital Gains
And always keep this in mind: rental real estate owners can avoid taxes indefinitely using Section 1031 exchanges (named after the applicable section of our beloved Internal Revenue Code).

The tax code totally mislabeled the 1031 exchange. It’s absolutely not an exchange or a swap. It works like this:

You sell your property.

You buy a new, more expensive property.

Your Section 1031 exchange intermediary (such as a bank) handles the paperwork, and that makes the taxes go away.

If you are considering converting your home into a rental property and would like my advice on the conversion, please contact me below.

Get a Free Tax Savings Consultation
Pinewood Consulting’s CPAs will help you assess your tax savings potential through a free consultation. Book yours today with Chad Pavel, CPA.

[peterjohnson]

Hey Chad, I enjoyed your informative video. I recently bought a house and then in 2023 renovated and rented out a different house that I had lived in and owned for 38 years. Since I have owned the rental house longer than the 27.5 year standard term of depreciation, on what basis can I claim a rate of depreciation? The renovation in 2023 consisted of repairs-drywall, paint, carpet, some light fixtures, appliances, bath/kitchen fixtures, flooring, deck resurfacing, cleaning and powerwashing. The roof was replaced due to weather damage in 2021 mostly with insurance funds. The house was also significantly renovated in 1995 largely with insurance funds due to a fire from a toaster oven causing extensive fire, smoke and water damage. Due to refinancing I still owe money on a mortgage for about a third of the current market value of the house.

[SinskariBoithree]

Thanks for the video! Very helpful and educative for the beginners 🤟🏻

[kimdj]

Thank you. Wow I learned so much from your video!

[nomadpocho]

Hey Chad, I would love a video on if I rent out a room in my house. Does opening an LLC work out in terms of the profit loss. Lots of mellenials are house hacking right now so I think this would be a great video for content. Great content btw!

[martinbaldovinos]

Would I have to refinance my home to make it a rental property? And if I do can I write off tax deductions for closing costs, down payment, etc?

[annestnntt]

Hey Chad, very informative video! I was wondering if your advice are transferable to Canadian owners experience? Would you be able to recommend any adviser that have an expertise for Canadians? Thanks

[Will-dskg]

Hey Chad, can you deduct expenses spent on repairs on your primary residence in the month BEFORE you move out and convert into a rental? Or should I wait until I move out to get the tax benefits of these repair expenses?

Thanks

[angiemeepster]

Hello, thanks so much for the info. I believe I qualify for the exception. I bought in 12/15/2017 and lived there as my primary until I rented it out on 01/01/2020. I rented until Jan 2022. I sold it on 08/10/2022. The house was vacant while listed. Can I still report a schedule E for the month of as rented? What is required tax wise for selling it while I had previously rented the house for 2 years?

[mlnn]

Hi Chad, I bought a second home in 2021 pandemic and stayed there for 4-5 months, then I furnished, upgraded the home for vacation rental. Can I deduct all furnishing cost (furniture & setup for vacation rental) as expense from rental income, and also can I deduct mortgage and utility payment from vacation rental income? Total rented days has been less than 180 days per year.

[withlove]

Hello Chad, if I bought the house for 150k 40 years ago, and now I start renting it out. what value of the house do I use for depreciation? Thanks so much for your help




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[dizluvjesus]

When rolling over 90% of the selling price of a home to a home owned for ten years, is section 1031 applicable?

[karyjimenez]

I am planing to deed my property residence as an llc entity taxable as S corp. So my question is can I still be living on that property that will convert my my investment real estate So, I am planning to report rent since I am planing to live there. Is that make sense?

[vegomatic]

Our primary and now rental home was bought in 1991and refinanced in 2005. We started renting the entire house in 2020. Can we use the tax assessed building and land values to determine the cost basis for depreciation? If so, do we use the values from the year the house was bought? The year we refinanced or; the year we started renting the house out? Thank you!

[roxannekoopman]

Hey Chad, Thanks for the video. Could you help me out with this question? I bought another house and paid it off in cash. I refinanced my primary residence to do it. I'm now renting out that second house. Can I use the mortgage interest on my primary residence as part of my loss for the rental house?

[ryanthegamercmaa]

I build a apartment in my backyard and a studio in my garage can I deduct what I invested

[elfpuncher]

Thanks for the video! We're moving out of our house we've owned for two years and plan to rent it out. Based on what you've said, It sounds like there wouldnt be any reason to get an appraisal to determine the value for basis purposes if the value is going to go up, correct?

[auntylizzyrocks]

Sorry, a tad confused. You said basis when you convert the home to a rental is your cost to purchase home plus improvements minus depreciation. What depreciation?

[yourlogicalnightmare]

Welp, looks like the government has stolen all my property rights. Apparently my tenant can pay zero rent for 2 years, I have to pay all his utilities then go through 3 months of eviction process. Thanks Covid 😃👍

[christineyoung]

Do I need to worry about it, if I only rent my room out? It’s my only primary resident and it’s because I couldn’t afford the full amount of Morgage payment.

[rick_the_agent]

Wait so if I own a 6 bedroom and I rent 2 bedrooms can I apply a Sch E for those 2 rooms ?