Are you thinking about moving into a new home and renting out your current home? Here are some things to consider.

Let’s start with the many nontax factors to consider when deciding whether to sell or rent out your current home. Do you need cash from the sale to fund the down payment on a new home? If so, you have no choice. Are there sentimental reasons not to sell? If the market is very soft, you may want to rent to wait for prices to rebound. Once you sort through all the nontax factors, here are some tax related items to consider.

As discussed further below, don’t turn a large excludable gain into a taxable one by failing the “2 out of 5” year rule. Even if you rent it for a while, you may still may to sell within the 5 year window.

If you rent, everyone loves the tax deductions! Income from a rental property must be reported to the IRS using Schedule E on your Form 1040. However, there are several deductions available to reduce the net income that is subject to tax. These deductions include insurance, property taxes, utilities, repairs, professional fees, property management fees, travel, and depreciation.

Depreciation is a very powerful tool in reducing tax liability on a rental property. When you convert a personal residence into a rental property you must first determine the cost basis of the property. This is determined by using the lesser of the initial cost of the property plus major improvements or fair market value at the date of conversion. The basis is then divided into land, building, furniture, fixture, and equipment (FF&E), land improvements, etc. Land cannot be depreciated, but we get to deduct the cost of the building over 27.5 years. FF&E and land improvements can be deducted in full in year one utilizing bonus depreciation under current law. Keep in mind any depreciation taken on the property will be recaptured at higher rates rather than long term capital gains in the year of sale.

Rental properties can provide positive cash flow while producing a tax loss due to depreciation expense, what a great deal! However, these losses are not always deductible in the year they are created. Losses created by rental properties are considered passive and are only deductible if you meet one of the following criteria: 1) Qualify for the special $25,000 allowance – If your modified adjusted gross income is less than $150,000 and you actively participate in the rental activity, you may be able to deduct some or all of your rental losses up to $25,000, 2) You have other passive activities that produce income during the year, or 3) You sell the rental activity during the year which allows you to deduct current year losses as well as any losses suspended from previous years. The good news is that any disallowed passive losses can be carried forward indefinitely until a future year in which you qualify to use them.

If you sell the property for more than your net tax basis, you have created a gain. Is this gain taxable? If so, how much of it is taxable? As is the answer to so many tax questions, it depends!

There are a few different ways to address a possible tax bill when deciding to sell your rental property.

  1. Read Carrie Christensen’s article in this KT Addition regarding the ability to exclude gains on sale of a primary residence. If you qualify for the “2 out of 5” year rule, your gain should be excluded.
  • While I won’t be covering it in detail in this article, a Section 1031 “Like-Kind Exchange” can be a powerful tool to defer tax if you no longer want to own this rental property (and you flunk the “2 out of 5” year rule—) but are still willing to own an investment property. This would delay any taxes until the replacement property is ultimately sold. Section 1031 exchanges are a complicated process and you should consult with your tax professional before you choose this route.
  • Once you have two homes, you then could sell your personal home instead of the rental property. If cash flow is what you need and your situation is right, selling your personal residence instead of the rental property could allow you to exclude all of the gain and provide you with the funds you need.  Remember you need to meet the requirements to exclude the gain on sale of your personal residence for this to work.
  • You could continue to rent out the property until you pass away, at which point the inheritor of the rental property would get the basis stepped up to fair market value.

As always, each situation is unique and you should speak with your tax professional prior to converting your personal residence into a rental property.