Talking Tax: What are the tax implications when we begin renting out our former home?

Peter G. Robbins, CPA//September 25, 2014

Talking Tax: What are the tax implications when we begin renting out our former home?

Peter G. Robbins, CPA//September 25, 2014

Peter-Robbins_CMYKQ: We are considering purchasing a new home. We are also considering keeping our current home and renting it. We have a small mortgage and regular taxes on this property, both of which are currently deducted on our return, and we will have a new mortgage and taxes on the home we purchase. Can we get a deduction for the interest and the taxes on both properties?

A: When you cease using your current home as a residence and begin renting it, the tax treatment changes quite a bit. Your old home will now be considered rental property and reported on Schedule E in your tax return. The rents received are reported as rental income, and most expenses related to the property can be deducted against that rental income. Your mortgage interest and property taxes on this property will no longer be deducted as itemized deductions on Schedule A of your return, but rather they will be deducted on Schedule E as rental expenses. In addition, many of the other expenses on this property will be deductible as rental expenses even though they were not deductible when the property was your personal residence. These expenses include insurance on the property, any utilities you pay, maintenance costs, management costs, home owner’s association dues, and other operating expenses. You can also begin to depreciate the property and any improvements made to the home. Obviously you will want to keep careful records of all the costs related to the rental.

The rental income and expense will be subject to a number of special tax rules, the most complex of which is the “passive loss rules.” Rental income is per se characterized as passive income and these rules are very complex. Generally, when the total of all the rental expenses exceed the rents received, you will only be able to deduct the net rental loss against other passive income. If this is your only passive investment, and if after depreciation it nets to a loss, this passive loss will not be currently deductible. You won’t report taxable income from the rental, but you really won’t get any immediate tax break from it either. The losses do however carryforward and can be used in future years when there is passive income, or they can be fully deducted when the property is sold. So there may be tax benefit to keeping the house as a rental property, but probably not until future years.

But every tax rule seems to have an exception. Up to $25,000 of rental losses can be deductible annually, despite these passive loss restrictions. You must be actively involved in the major management decisions regarding the rental property, and your total page one 1040 income (Adjusted Gross Income) must be under $100,000. For incomes between $100,000 and $150,000, the $25,000 rental loss allowance is phased out proportionately.

One important downside of converting the personal residence to a rental property is that, assuming you keep the property as a rental for several years, you will lose the gain exclusion on the sale of a residence. Generally, if you own and use a personal residence for two out of five years you are able to exclude up to $250,000 of gain when you sell it. A married couple can exclude up to $500,000 of gain. If the residence is sold fairly soon after it is converted you may still be able to use a portion of this exclusion, but if you rent the home for more than 36 months you will completely lose this generous tax benefit.

The mortgage interest and property taxes on the new residence will be deductible on Schedule A of your return just as they were on your old residence. If the debt on the new residence exceeds $1,100,000 a limitation on this deduction will apply, and there is also a phase-out of these deductions if your income exceeds certain thresholds. Also, property taxes are not deductible for purposes of the Alternative Minimum Tax (AMT).

You question on the surface seems simple, but our current tax code makes a complete answer very complex. Consequently you should consult your tax advisor for a more thorough answer. In situations like this I usually run a comparative tax projection so all the limitations and phase-outs can be considered.

Good luck with the move and finding a suitable rentor!

Peter Robbins is a principal in the Boise office of CliftonLarsonAllen, LLP specializing in tax matters for small businesses, individuals, and trusts and estates. CliftonLarsonAllen, LLP is one of the ten largest public accounting firms in the nation offering unprecedented emphasis on serving privately held businesses and their owners, nonprofits, and governmental entities. The answers in this column are meant to offer general information. You should consult your tax advisor regarding the specifics of your situation.

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