Be Aware of the Tax Consequences of Renting Out Your Primary Residence

In several sections of the nation, residential real estate values have risen sharply since the financial crisis and real estate crisis of 2007–09. The rise in property values has prompted people to rethink their options when it comes to selling or renting out their homes.

Unlike a home, rental property is taxed differently. To avoid paying capital gains taxes on the sale of a home, it may be tempting to rent out the current property for a period of time.

The choice to change the main residence into a rental property may also be a bad tax move for homeowners.

Tax Benefits When Selling Your Personal Residence

Since 1997, homeowners have been allowed to defer up to $250,000 ($500,000 if married filing jointly) of gain on the sale of a property using the Section 121 exception. Taxpayers must have owned and used the property as a principal home for at least two of the last five years in order to qualify. Moreover, these two years need not be the most recent two years. Taxpayers who buy a house in 2017 and remain in it until they sell it in 2021 are still eligible to deduct the gain on the sale.

Example 1: In June 2011, Jolene and Max paid $400,000 for their home. They’ll go for $850,000 when they’re put up for sale in June of 2021. Because their total gain is less than $500,000, none of that gain has to be recorded as taxable income when they sell their property.

When Luke and Jenny bought their house in June of 2011, it cost $400,000. They will be sold for $1,050,000 in June of 2021. As a result of their $650,000 profit, they must include in their taxable income the additional $150,000 that is beyond the $500,000 exclusion threshold limit. Long-term capital gains rates apply to the $150,000 gain. (Note: Luke and Jenny may be able to deduct some of the remodeling expenses from the $400,000 purchase price if they completed a lot of work.)

Understanding the Tax Implications of Investing in a Rental Property in Your Primary Residence

Owners frequently have two alternatives when they decide to move into a new home: they may either sell their current residence or convert it into an investment opportunity for renters. While the possibility of obtaining a monthly rental income from your main residence may be appealing, the tax consequences of making your home a rental property may outweigh the benefits if you ever decide to sell.

To avoid having to sell their home in June of 2021, Jolene and Max from Example 1 will instead convert their home into a rental property. This home will be sold for $850,000 in June of 2023 when the owners decide after two years that they do not want to remain landlords any longer. They are still eligible for the Section 121 exclusion since they have resided in the home as their principal residence for at least two out of the previous five years, at least. It’s not necessary for them to prorate the gain between periods of qualifying and non-qualifying usage since the rental period occurred after they resided in the home as their main residence, so they don’t even have to do that. Only the recoupment of any depreciation absorbed during the rental term should be recorded as revenue.

As an alternative to selling, Jolene and Max from Example 1 decide to convert their home into a rental in June 2021. For the next four years, they’ll be renting it out and then selling it for $850,000 in June 2025.

In June 2025, they will be selling their home, which has only been utilised as a habitation once in the previous five years. Section 121 no longer applies to them. Their taxable income will include the whole $450,000 profit. Depreciation that was taken throughout the rental term must also be recouped.

After renting their home for four years, Jolene and Max’s tax payment was much greater than if they had sold the property immediately or if they had sold it after renting the property for just a few years.

Possibilities for Renting Out Previously Owned Real Estate

If you’re in the position of Jolene and Max in example 4, you have a number of options for strategic planning. Among them are:

  1. regain exclusion by re-entering the property.
  2. As long as you’re renting it out, you’re not eligible for a step-up on a monthly basis.
  3. Section 1031 exchanges into a different rental property are an option to consider.
  4. Consider selling your primary home and purchasing a second rental property.

To regain your exclusion, return to the property.

Some of the exclusion may be regained by returning to the rented property.

Using Tina and Troy as an example, the couple bought their home for $400,000. In June of that year, they converted it into a rental. They plan to put the home on the market in June 2019. All profits are taxed since the property has been rented out for the last four years.

For $850,000, they plan to return to their home in June 2019 and put it on the market in June 2021. It’s no longer a second home, thus they’re no longer subject to the Section 121 exception.

In 2021, when they sell their home, it will have six years of qualified use as a personal residence and four years of non-qualified use as a rental property. The $450,000 in earnings will be divided into $270,000 in gains that can be excluded and $180,000 in gains that can’t be excluded, based on the following formula: $450,000 x 60% = $270,000.

All depreciation accumulated throughout the four years as rental property will be included in the sale proceeds and taxed accordingly.

Tina and Troy were able to exclude some, but not all, of the profits from the years they held the property by moving back into their rental property for two years.

Until you are eligible for a step-up in cost basis, keep the property rented out as long as possible.

An asset’s cost base is stepped up when its owner dies, currently. Taxable gains are eliminated and the cost basis is “reset” as if the taxpayer had acquired the item at the time of his or her passing.

Instead of returning to their home in 2019, Tina and Troy from Example 5 continue to rent it out. Troy is in poor health and they reside in Washington. Upon Troy’s demise, the rental property will be valued at $850,000.

Tina’s cost of living rose significantly. Since then, it’s been handled as though she paid $850,000 for the home out of her own pocket. No taxable income is generated if she sells the home for $850,000, regardless of whether it is a personal or commercial property.

Troy and Tina are presumed to reside in a state like Washington, which recognises community property rights (or California, Texas, or several others). This step-up in the cost base is unlikely to be available to taxpayers who reside in a common-law state. In addition to the capital gains, landlords benefit from a step-up in depreciation, making the tax savings even more significant.

Exchange your rental property for another under Section 1031 of the Internal Revenue Code

Taxpayers may delay taxes on a Section 1031 exchange into a new rental property if they no longer wish to rent out their present property but are still willing to have a rental property. The cost basis of one rental property may be transferred to another if the taxpayer sells the previous one and buys the new one. Until the new rental property is sold, no taxes will be due on the property.

Working with a broker that specialises in 1031 exchanges is a difficult task. Rental properties may only be used for this trade. A rental home cannot be converted into the main residence using this method.

Purchase a New Rental Property after Selling the Principal Residence

The ultimate option is to ignore the problem entirely. Sell your primary residence and buy another rental property to save money on taxes when you’re moving out of your home and desire a rental property of your own.

The taxpayer may exclude all profits up to the Section 121 exclusion amount of $250,000 or $500,000 by selling their primary house before renting it out. For this reason, a new rental property may be acquired and maintained with a “reset” higher cost base for the new investment.

Conclusion

In the event that you’re moving out of a home, you may want to consider renting it out. An increase in cash flow from a rental property could be advantageous.

You should, however, think twice before renting out a house that has appreciated significantly in value when you move. If you decide to rent out your home, you may lose more tax advantages than you gain in new rental revenue because of this.

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