Recovering real estate values may cause some homeowners to consider converting their
personal residence to rental property for investment purposes. The process for making
this decision should include an analysis of economic factors, such as the homeowners'
marginal tax rate and the potential loss of the ability to exclude up to $250,000
($500,000, if married) of gain from the sale of their principal residence for federal
income tax purposes.
Other economic factors to consider include the expected growth rate for rental
property in the area, length of time the house will be rented before being sold, cash
flow from renting, effect of passive activity rules (which limit and defer tax
deductions), and expected rate of return available on other investments. Generally,
the economic advantage of converting a personal residence to a rental rather than
selling it is increased as the growth rate of the rental property increases and the
rate of return on alternative investments decreases, but each situation should be
thoroughly analyzed based on its particular facts and circumstances.
If selling a personal residence would result in a nondeductible loss, the homeowner
can seriously consider converting the residence to a rental property. Tax-saving
opportunities generally are limited for residential rental conversions, primarily
because of the passive activity loss rules. However, converting a personal residence
into rental property may allow the homeowner to eventually recognize a loss for tax
purposes on the property's subsequent sale if the property continues to decline in
value, and thus provide cash flow in the interim.
The fact that a residence is rented at the time of the sale does not automatically
preclude gain attributable to such use to be excluded under the gain exclusion rules.
Instead, the exclusion of gain depends on whether the homeowner meets the ownership
and use requirements and the one-sale-in-two-years test at the time of the sale.
The decision to convert a residence to rental or investment property is complex, and
the ramifications of this decision are far-reaching. Please contact us to thoroughly
explore the numerous tax and economic issues related to such a conversion.
This publication is distributed with the understanding that the author, publisher and
distributor are not rendering legal, accounting or other professional advice or
opinions on specific facts or matters, and, accordingly, assume no liability
whatsoever in connection with its use. The information contained in this newsletter
was not intended or written to be used and cannot be used for the purpose of (1)
avoiding tax-related penalties prescribed by the Internal Revenue Code or (2)
promoting or marketing any tax-related matter addressed herein. © 2014