Converting a home to or from a rental property has many advantages, as well as a few setbacks that homeowners should be aware of prior to deciding. One of the main differences for tax-filing purposes is that the Schedule E, Income and Loss from Rental Real Estate and Royalties, must be included within the individual return if engaging in rental activity. The inclusion of the SCH E results in different tax treatments for capital gains and depreciation, as well as additional deductions.

Rental Income/Expenses:

Rental income includes all amounts received – including additional fees in excess of rent. Rental expenses include any expenses associated with the managing/maintaining of a property. Some of these deductions include property management fees, repairs, maintenance, insurance premiums, utilities, advertising costs, mortgage interest, property taxes, and legal/professional fees, etc.

Depreciation Deduction: 

Homeowners cannot depreciate their primary residences because they are not considered to be business assets. However, converting a primary residence to a rental property allows you to depreciate the home and improvements; usually over a period of 27.5 years using the MACRS system.

Splitting Depreciation by Time Spent for Rental Purposes/Personal Purposes:

To claim the depreciation deduction, either the cost basis or fair market value at the time of conversion must be used, instead of the original value that the home was purchased for. When converting a rental property to a primary residence, depreciation can only be taken for the period of time that the property was a rental during the tax year. This depreciable amount is usually prorated by the number of months.

Splitting Depreciation by Portion or Square Footage Used for Rental Purposes/Personal Purposes:

In circumstances where a property is only partially converted to a rental and still serves the purpose of primary residence, the whole property’s depreciable basis is multiplied by the rental-usage percentage of the property which determines the rental’s depreciable basis. To find this rental-usage percentage, the rental square footage is divided by the total property square footage.

It’s important to remember that land can never be depreciated. In any calculations, the value of land must be subtracted from total property value to find depreciable basis. 

Conversion Date: 

Converting a rental property to a personal residence or vice versa will cause tax complications, specifically, relating to the deductible portion of property expenses for the year. Property expenses should be multiplied by either the rental usage percentage (square footage) or rental usage time (days or months) as described in the example of depreciation.

Section 1031 Exchange

Another advantage of converting a home to a rental property is the Section 1031 Exchange, through which owners can exchange like-kind business properties of equal or higher value and defer capital gains tax to the selling of the replacement property. This allows for the transfer of property and reinvesting of equity with no current tax liability. 1031 exchanges require the filing of Form 8824 with your tax return. 

For the Section 1031 Exchange to be valid, timing is a very important factor. Three or fewer potential replacement properties must be identified to the IRS within 45 days of selling the initial property, followed by the purchase of one or more of the disclosed properties. If the purchased ‘replacement’ property is not one of the disclosed properties, the Section 1031 exchange is invalid. In addition, you must close on one of the disclosed properties within the 180-day window – you actually have the lesser of 180 days or your next tax filing due date. Returns can be put on extension to extend this amount of time if tax filing time is initially less than 180 days – thus providing the taxpayer with a full 180-day window to close on at least one of the properties. Section 1031 exchanges can also be used multiple times in a series, meaning that the initial replacement property can be replaced with a new replacement property, so long as all the criteria are met.

Section 121 Exclusion

Unlike the Section 1031 Exchange, the Section 121 Exclusion only applies to principal residences and allows capital gains up to $250,000 from the sale of a home to be excluded from taxable income for an individual, and up to $500,000 if married, filing jointly. To qualify as a Section 121 Exclusion, a taxpayer must use the home as a primary residence for a total of 2 years (on and off residence is permitted) within the 5 years leading up to the sale. 

This information has been prepared for informational purposes only, and is not intended to provide, and should not be relied upon for tax, legal, or accounting advice. If you have any questions regarding converting a home to or from a rental property, please do not hesitate to contact us at Lear & Pannepacker.