Key Takeaways:
- Converting your primary residence into a rental property can generate passive income and offer valuable tax deductions like mortgage interest, repairs, and depreciation.
- The IRS allows you to depreciate your rental property (excluding land) over 27.5 years, reducing your taxable rental income annually.
- When selling, depreciation recapture requires you to pay tax—up to 25%—on the total depreciation claimed during ownership.
- The Section 121 exclusion may let you exclude up to $250,000 ($500,000 if married filing jointly) of capital gains if you meet ownership and residency requirements, but it does not apply to depreciation recapture.
- Careful tracking of rental expenses and income is critical for accurate tax reporting and to prepare for taxes owed on both capital gains and depreciation recapture when you sell.
Real estate has long been considered one of the greatest long-term investments. Further, with the trend of minimalist living, many are turning their primary residences into rental properties. While converting your home to a rental property comes with passive income and tax benefits, it’s important to note the tax implications as well.
Benefits of Converting Your Primary Residence to a Rental Property
Passive income is just one of the benefits of converting your home into rental property, but there are plenty of others.
Tax Deductions
Deducting the expenses related to your rental property can decrease the income reported on your tax return. Every property is different, but the most common expenses you can deduct include:
- Cleaning and maintenance
- Property taxes
- Commission fees
- Repairs
- Insurance
- Mortgage interest
Depreciation Expenses
The IRS allows you to depreciate your rental property over a 27.5-year period in order to account for things like wear and tear and deterioration. Taxpayers can do this by taking the value of their home at the time of conversion, less the land value, and then dividing it by 27.5 years to calculate the annual depreciation expense. If your depreciation expense is greater than your rental income in a given year, no taxes are owed on the income.
Tax Impact of Selling a Rental Property
While the benefits sound nice, it is critical to understand the tax implications that come with not only owning a rental property, but also those that accompany selling one.
Capital Gains
In the selling process, timing is everything because it will determine the amount of capital gains tax paid, if any. Capital gains tax is tax owed on the profit earned on an asset upon selling it. It can be found by a simple calculation:
Final Sale Price – (Asset’s Original Cost + Expenses Incurred)
The IRS Section 121 exclusion allows taxpayers to exclude up to $250,000 of the gain from the sale of your rental property. The amount increases to $500,000 if married filing jointly. To qualify, the taxpayer must own and use the property as their primary residence for two of the past five years. If a taxpayer sells their residence during a time of using the property as their primary residence for only one of the past five years, they would no longer be eligible for the Section 121 exclusion. In this case, the taxpayer would need to report the gain of the sale in their taxable income.
How Depreciation Affects Capital Gains
One key consideration that often catches rental property owners off guard is how depreciation impacts capital gains when the property is sold. When you depreciate a rental property, you’re essentially reducing your taxable rental income each year based on the property’s wear and tear. However, when it’s time to sell, the IRS requires that you “recapture” this depreciation.
This process is known as depreciation recapture, and it means the total amount of depreciation you’ve claimed over the years is taxed separately—typically at a rate of 25%. This is in addition to any capital gains tax you may owe on the property’s appreciation in value.
Example Scenario
You bought a home for $300,000 and lived in it for 5 years. Then, you converted it into a rental property and owned it for another 5 years. During those 5 rental years, you depreciated the property at $9,000 per year, totaling $45,000 in depreciation. Then, you decide to sell the property for $450,000.
Step 1: Calculate Adjusted Basis and Gain
Let’s say your original purchase price was $300,000, and you incurred $5,000 in selling costs.
- Adjusted basis: $300,000 (purchase price) – $45,000 (depreciation taken) = $255,000
- Capital gain: $450,000 (sale price) – $255,000 (adjusted basis) – $5,000 (selling costs) = $190,000
Step 2: Separate Capital Gain and Depreciation Recapture
- Depreciation recapture: $45,000 (taxed at up to 25%)
- Remaining capital gain: $190,000 – $45,000 = $145,000 (taxed at capital gains rates, typically 15% or 20% depending on your income)
Step 3: Estimate Tax Owed
- Depreciation recapture tax: $45,000 × 25% = $11,250
- Capital gains tax: $145,000 × 15% = $21,750 (assuming you’re in the 15% capital gains bracket)
Total estimated taxes owed on sale:
$11,250 + $21,750 = $33,000
Frequently Asked Questions
Q: What are the benefits of converting my primary residence into a rental property?
A; Converting your home into a rental property can provide passive income and various tax benefits, including deductions for expenses like cleaning, repairs, property taxes, mortgage interest, and depreciation.
Q: What expenses can I deduct as a rental property owner?
A: You can typically deduct costs such as cleaning and maintenance, property taxes, commission fees, repairs, insurance, mortgage interest, and annual depreciation over 27.5 years.
Q: How does depreciation work for rental properties?
A: The IRS allows you to depreciate the value of your rental property (excluding land) over 27.5 years to account for wear and tear. This reduces your taxable rental income each year.
Q: What tax implications should I be aware of when selling a rental property?
A: When selling, you may owe capital gains tax on the profit from the sale. Additionally, depreciation recapture tax applies on the total depreciation claimed during ownership, taxed up to 25%.
Tax Debt Relief for Rental Property Owners
Tax implications revolving real estate can be extremely tricky. If you’re planning on converting your home to a rental property, it’s important to make sure you are keeping track of all rental property expenses and income to ensure accurate reporting during tax time. Optima Tax Relief is the nation’s leading tax resolution firm with over a decade of experience helping taxpayers.
If You Need Tax Help, Contact Us Today for a Free Consultation