When converting a property that was your home into a rental property, there are a number of tax implications to be aware of. Many of these tax consequences also apply if you move out of your home and hold it for a period of time as an investment property in hopes that it appreciates in value, because that is also considered to be real estate that is held for an income producing purpose.
Loss of the Section 121 Exclusion
The first consideration that I always tell my tax clients when they are converting a home to a rental is that they need to be aware that if they keep it as a rental for a number of years, they’ll be giving up the section 121 capital gains exclusion. That is the tax provision that allows you to forgo having to pay capital gains taxes on $250,000 or $500,000 of your profit from the sale of your primary residence. You generally only qualify for that benefit if you lived in the home at least two out of the last five years before the date you sell it.
So what you don’t want to do is convert your home to a rental property for several years, making you ineligible for section 121, and then decide you want to sell it. But if you plan to either only rent it out for a short time, or you plan to instead keep it as a rental for a long time before selling it, then converting it to a rental can be a good plan.
Calculating the Depreciation Basis
Your depreciation basis is the value of the property that you can depreciate while it is a rental property, which means you can deduct a portion of that cost each year as an expense against the rental income. The amount you can depreciate is based on your adjusted basis, which is the value you paid for the property, plus any renovation costs, then subtracting any past accumulated depreciation, including past rental use or a home office. Land can’t be depreciated, so you must also subtract out the value of the land to arrive at the portion that you can depreciate.
But if the fair market value of the property on the date that you convert it from a personal use property to a rental property is less than the adjusted basis, then you must instead use that lower fair market value of the home as the value that you can depreciate (after subtracting the land value portion).
The Placed-in-Service Date
The date when the property is first available to be rented, and it is also advertised somewhere in some way to make potential renters aware that it can be rented, that is your placed-in-service date. That is the date when depreciation of the property as a rental (and any other assets such as furniture) begins. It’s also the date from which you can deduct subsequent expenses, such as mortgage interest and property taxes, as deductions on your Schedule E for the current tax year.
Dividing of Expenses
Mortgage interest and the portion of property taxes that apply to the portion of the year after the placed-in-service date are deductible as an expense for the rental property (on Schedule E). Mortgage interest and property taxes for the portion of the year before the placed-in-service date are potentially deductible on your Schedule A as an itemized deduction if you have enough itemized deductions to exceed your standard deduction.
Personal Use Days
When you convert a home to a rental, you’ll generally need to be sure to rent it out at least 14 days that year if you want to qualify to deduct expenses related to the rental that year. If you lived in it or used the property for personal use of more than 14 days (either before or after the home was converted to a rental), and you rented it out less than 15 days during that year, then the “Augusta Rule” applies, and you may not deduct any expenses for the rental that tax year (sections 280A(g) and 280A(d) of the tax code). But thankfully, any income you earned while renting it out that year is also not included in your taxable income.
A similar provision applies if you make it available to rent but are unable to acquire a paying renter at all that year. In that case, if you had any personal use days that same tax year at all, and you had zero rented days, then section 280A(e)(1) of the tax code indicates that you wouldn’t be able to deduct any expenses for the rental property that year.
And finally, if you have more than 14 days of personal use after the home is converted to a rental, and those personal days are also greater than 10% of the number of rented days, then the property is considered a personal residence under 280A(d), and the consequence is that your deductible expenses are limited to the amount of rental income. Note that for purposes of this provision, only personal use days after the home is converted to a rental apply, as long as the home remains a rental for at least 12 months (or it is sold within that time). The other limitations previously mentioned apply to any personal use days that occur either before or after the home is converted to a rental.
If deductible expenses on the property are limited due to personal use, the disallowed amount does get carried forward to future tax years as a “carryover of unallowed expenses”. That amount is generally tracked for your records by your tax software on IRS Publication 527’s Worksheet 5-1 “Worksheet for Figuring Rental Deductions for a Dwelling Unit Used as a Home”. This carryover amount can offset future income from the same property.
Summary
Converting your home into a rental property involves navigating complex tax rules. By understanding the implications of the Section 121 exclusion, depreciation basis, placed-in-service date, and personal use limitations, you can make informed decisions that optimize your tax benefits and minimize potential pitfalls. Proper planning and awareness of these rules are crucial to ensuring that the transition from personal residence to rental property is financially beneficial.
