Converting a Residence to a Rental Property

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.

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