Tax Rules on Renting Out a Personal Residence

handing over home keys
Natee_Meepian_istock_homerental

The other day, I received an e-mail from a couple I’ll call David and Ruth. They both work and own a 3-bedroom home that costs them just $1,000 monthly for real estate taxes and mortgage payments.

As they plan to move into a new dwelling, one option is to convert their present place into rental property. Ruth asks whether that would be a sensible move. My answer is that it all depends and their decision is an inherently subjective one.

Viewed solely from the perspective of taxes, it could be a savvy maneuver. The couple could sell and qualify for an exclusion that allows them to escape taxes on as much as $500,000 of profit from the sale ($250,000 for single filers), provided they've used the place for at least two years out of the five-year period that ends on the sale date and at least two years have elapsed since they last used the exclusion. Then they could use the proceeds, mostly or entirely diminished by taxes, for investments or that new home.

Or the couple could decide not to sell and become landlords. Then they get to offset their rental receipts with deductions for operating expenses, such as utilities, repairs and insurance, plus depreciation. I remind them to be mindful that the rules for calculating depreciation take some twists and turns.

The measure of the depreciable amount is the lower of

  1. the property's adjusted basis at the time of conversion or
  2. fair market value at the time of conversion  

Their adjusted basis in most cases is cost plus certain settlement or closing costs connected with the purchase, such as legal fees or title searches, and improvements, such as additional rooms or major renovations. They can’t take land into account as it’s not depreciable.

What if the newly-minted landlords show a profit? It’s taxed as ordinary income, just the same as their salaries.

What if David and Ruth show a loss, as is not uncommon because of depreciation write-offs? Then, they should be able to use the loss as an off-set against their salaries and other kinds of income.

First, though, the couple needs to familiarize themselves with the rules for rental-property losses. Generally, such losses are subject to the restrictive rules for tax-shelter deals and can offset only income from shelter arrangements, such as limited partnerships. Shelter losses can’t shield from taxation non-shelter income, such as wages and withdrawals from IRAs and other kinds of tax-deferred retirement accounts.

These tough restrictions are subject to several exceptions, including a special break for most owners of rental property who qualify as "active" managers—IRS-speak for those helping to make decisions on such things as approving tenants, setting rental terms and approving capital improvement projects.

The law allows owners like David and Ruth to deduct up to $25,000 in losses against other income. The cap drops from $25,000 to $12,500 for married persons filing separate returns and living apart at all times during the year and becomes zero for marrieds who live together and file separately.

It’s not for fat cats. The break begins to phase out when modified adjusted gross income exceeds $100,000, and vanishes entirely when AGI surpasses $150,000. For marrieds filing separately, the $100,000 and $150,000 figures become $50,000 and $75,000. But unused losses can be carried forward to later years.

As of now, no problem for joint filers like David and Ruth. Their modified AGI is well below the magic number of $100,000. But they should keep in mind that claiming rental losses increases the likelihood of an audit.

The IRS suspects that many landlords are incorrectly deducting losses. If the agency's computers bounce their return, they should expect the examiner to require proof of their active participation in management decisions, ownership of an at-least-ten-percent interest and correct computation of the deduction under the modified AGI test.

Additional articles. A reminder for accountants who would welcome advice on how to alert clients to tactics that trim taxes for this year and even give a head start for next year: Delve into the archive of my articles (more than 250 and counting). 

About Julian Block

Julian Block

Attorney and author Julian Block is frequently quoted in the New York Times, Wall Street Journal, and the Washington Post. He has been cited as “a leading tax professional” (New York Times), an “accomplished writer on taxes” (Wall Street Journal), and “an authority on tax planning” (Financial Planning magazine). More information about his books can be found at julianblocktaxexpert.com

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avatar
May 4th 2018 20:34

What about recapture of depreciation upon the sale of the rental property, not subject to capital gains rates, instead subject to ordinary income tax rates.

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to Highlifeii
May 7th 2018 05:18

That's a topic for another column. I'll keep it in mind when I discuss sales of rental property. Thanks for the reminder.

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avatar
May 8th 2018 17:19

I always use "24 of 60 months" when discussing the exclusion of gain on sale of a principal residence. I have a client whose prior accountant advised them "two of the five years" being the rule. They lived in the dwelling in December thru the next August, thus during 2 of the 5 years. The gain was not huge, but it was an unexpected addition to their taxable income.

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to WheelerEA
May 14th 2018 16:02

Another way is to say at least two out of the five years that end on the sale date. Perhaps there are others who would like to weigh in.

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