Even though the residential real estate market is slowly starting to recover, it’s still clearly a buyer’s market. That being said, homeowners are looking to take advantage of the depressed values but are finding it difficult to sell their existing personal residence. One option is to convert one’s existing personal residence to a rental property. While there are many economic factors to consider when making this decision, it’s important that certain facts and circumstances be established if a homeowner decides to convert the property to a rental activity and obtain the resulting income tax benefits.
Is This a Bona Fide Rental Activity?
Homeowners who decide to convert their personal residence to a rental property must be able to establish that it’s their intent not to move back into the residence but to rent the property until it is ultimately sold. There are numerous court cases analyzing whether taxpayers established the necessary facts and circumstances as to whether a personal residence was properly converted to a rental property. In some instances the taxpayers were successful in establishing the conversion to a rental property, but in others they were not.
Some of the facts and circumstances that are helpful to establish that a property has been converted to a rental are:
- Moving out of the property by removing all personal property
- Listing one’s prior residence diligently for rent and actively trying to rent it
- Never returning to the house to live in it
- Purchasing a new home
- Registering to vote in a new area
- Changing all mail to a new residence
- Changing one’s driver’s license to a new residence
- The length of time that property is held for rental prior to its sale
What Deductions May Be Claimed on This Rental Activity?
The rental income and related expenses must be reported on Schedule E of the individual's income tax return. Therefore, mortgage interest expense and real estate taxes that were once reported on Schedule A, “Itemized Deductions,” will move to Schedule E of one’s individual income tax return. Other expenses that may be claimed against the rental income are deductions for the money spent on insurance, utilities, operating expenses, and incidental repairs and maintenance (such as fixing a leak in the roof). Once a property has been converted to rental property and placed in service, depreciation on the converted residence begins as well; this depreciation will be based on the lower of the homeowner’s tax basis or the property’s fair market value on the date of its conversion.
While there are many advantages and tax savings opportunities inherent in converting to a rental property, there are many tax complications as well. Due to the passive activity loss rules, a taxpayer may not be able to currently deduct the rent-related deductions that exceed the rental income unless one of a few exceptions applies. Also, when the property is ultimately sold, the basis of the property and the character of the gain or loss will vary depending upon the facts on the sale date.
It’s clear that certain facts and circumstances must exist to support the position of converting a personal residence to rental property, and careful tax planning is essential to ensure tax savings opportunities are maximized. If you are contemplating such a transaction, or your previous personal residence has been on the market for quite some time, please give us a call, and let us help you maximize your tax benefits!