Residential real estate prices are climbing in many areas, and rental rates are strong. To take advantage of this favorable situation, you might be thinking about buying a new residence and converting your existing place into a rental property that you can sell later for a higher price. Good idea!
Of course, converting a personal residence into a rental has important tax implications. Here’s Part 2 of what you need to know. For Part 1, see here.
Landlord tax rules in a nutshell
Once you’ve converted a former personal residence into a rental, you must follow the tax rules for landlords. What fun! Here is a quick-and-dirty summary of the most important things to know.
What you can write off
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 tax basis of a residential building over 27.5 years, even while it is (you hope) increasing in value. Say the basis of your rental property (not including the land), as determined under the rules explained here, is $400,000. Your annual depreciation deduction is $14,505, which means you can have that much in positive cash flow without owing any income taxes. Nice!
But beware of dreaded passive loss rules
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 only allow you to deduct passive losses to the extent you have passive income from other sources–like positive income from other rental properties or gains from selling them. Passive losses in excess of passive income are suspended until you either have more passive income or you sell the property or properties that produced the losses.
Bottom line: the PAL rules can postpone rental property loss deductions, sometimes for many years. Fortunately, there are exceptions to the PAL rules that can allow you to deduct losses sooner rather than later.
What if you have positive taxable income from your rental?
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.
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%, so it’s a wonderful thing when you don’t have to pay it.
One bad thing: positive passive income from rental real estate can get socked with the 3.8% net investment income tax (NIIT) and gains from selling properties can also get hit. However, the NIIT only hits upper-income folks. Consult your tax adviser for details.
Taxpayer-friendly rules when you sell
Assuming the current federal income tax regime (or something close to it) is still in place when you sell your rental property, favorable rules apply.
Gain exclusion deal may be available
If you sell your former principal residence within three years after converting it into a rental, the federal home sale gain exclusion break will usually be available. Under that break, you can shelter up to $250,000 of otherwise-taxable gain or up to $500,000 if you are married. However, you cannot shelter gain attributable to depreciation, including depreciation claimed after you convert the property to a rental.
Results with not gain exclusion
When you sell a rental property that you’ve owned for more than one year and the gain exclusion deal is unavailable, the tax gain (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. As such, it is taxed under the current rules at a federal rate of no more than 20%, or 23.8% if you owe the 3.8% net investment income tax (NIIT).
However, part of the gain — an amount equal to the cumulative depreciation deductions claimed for the property — is subject to a 25% maximum federal rate, or 28.8% if you owe the 3.8% NIIT.
The rest of your gain will be taxed at a maximum federal rate of no more than 20% (or 23.8%). Don’t forget that you may also owe state and local income taxes on real estate gains.
It’s important to remember that property appreciation is not taxed until you actually sell. Good properties can generate the kind of compound tax-deferred growth that investors dream about. You can even pocket part of your appreciation in advance by taking out a second mortgage against the property or by refinancing with a bigger first mortgage. Such cash-out deals are tax-free.
Key point: Remember those suspended passive losses we talked about earlier? You can use them to shelter otherwise-taxable gains from selling an appreciated rental property.
Section 1031 exchange can defer tax hit from selling
The tax law allows rental real estate owners to unload appreciated properties while deferring the federal income hit indefinitely. Here we are talking about Section 1031 exchanges (named after the applicable section of our beloved Internal Revenue Code).
With a 1031 exchange, you swap the property you want to unload for another property (the so-called replacement property). You’re allowed to put off paying taxes until you sell the replacement property. Or when you’re ready to unload the replacement property, you can arrange yet another 1031 exchange and continue deferring taxes.
While you cannot cash in your real estate investments by making 1031 exchanges, you can trade holdings in one area for properties in more-promising locations. In fact, the 1031 exchange rules give you tons of flexibility when selecting replacement properties. For example, you could swap an expensive single-family rental house for small apartment building, an interest in a strip shopping center, or even raw land.
All things considered, the tax rules after you become a landlord are pretty favorable. But they are complicated. Consider seeking professional advice before making a final decision on a conversion.
Three favorable exceptions to the PAL rules
Exception No. 1: for “active” investors
The most widely-available exception says you can deduct up to $25,000 of rental property PALs if: (1) your modified adjusted gross income (MAGI) is no more than $100,000 and (2) you actively participate in the property. Active participation means at least making property management decisions like approving tenants, signing leases, authorizing repairs, and so forth. You don’t have to mow lawns or snake out drains to pass the active participation test.
If your MAGI is between $100,000 and $150,000, the exception is phased out pro-rata. For example, say your MAGI is $125,000. You can deduct up to $12,500 of PALs from rental properties in which you actively participate (half the $25,000 maximum). If your MAGI exceeds $150,000, you are completely ineligible for the active participation exception.
Exception No. 2: for real estate pros
This second exception is only available to folks we will call real estate professionals. To be eligible, you must spend over 750 hours during the year in real estate activities (including non-rental activities such as acting as a realtor or real estate broker) in which you materially participate. In addition, the hours you spend on real estate activities in which you materially participate must exceed 50% of all the time you spend working in personal service activities. If you clear these hurdles, losses from rental properties in which you materially participate are exempt from the PAL rules, and you can generally deduct them in the year they are incurred.
Meeting the material participation standard is harder than passing the Exception No. 1 active participation test. The three easiest ways to meet the material participation standard for a rental property are by:
1. Making sure the time you spend on the property during the year constitutes substantially all the time spent by all individuals (including non-owners).
2. Spending more than 100 hours on the property and making sure no other individual spends more time than you.
3. Spending over than 500 hours on the property.
Exception No. 3: For short-term rentals
Say you rent out your property on a short-term basis through Airbnb or VRBO. If the average rental period for your property is seven days or less, you can avoid the PAL rules by materially participating in the property, as explained immediately above. Then you can generally deduct rental losses from the property in the year they are incurred.