Thinking of Becoming a Landlord?
Property ownership and real estate investment are good means of increasing wealth on a long-term view. Are you giving thought to turning your primary residence into a rental property? You need to consider several most important things before taking the role of a property investor and landlord—with emphasis on tax.
What legal issues do I need to know in converting a primary home into a rental?
If you have full possession of the property as it is paid in cash, you can absolutely do what you intend to with the home provided that the HOA allows renting it out. It is good to review and read the Covenants, Conditions, and Restrictions (CC&Rs) of the community.
If the home is still under a loan, it is imperative to check your original mortgage documents. The terms of your loan would specifically indicate the intended use of the property. So if the lender has it on record that it is occupied for your primary residence, you are not allowed to use it as rental after the purchase. Certain loans also require a specified number of years in using it as a primary home before you are allowed to utilize it as an investment property. Failure to meet the agreement may be considered as bank fraud, and lead to prison.
A safe strategy which can be done is by refinancing your home and changing the owner-occupied loan with an investment property loan, wherein the latter has higher rates.
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How do I qualify for tax benefits when selling a primary residence?
Homeowners have taken advantage of the Section 121 exclusion to exclude up to $250,000 in profit from the sale of the main home (or $500,000 if married filing jointly) as long as you must have owned and lived in the home for a minimum of two years—within the past five years prior to the date of sale. These two years do not need to be consecutive. You could have lived there in 2018, then in 2020, and sell the house in 2022.
Example 1: Rox purchased her house in 2019 for $180,000. She moved out of the state in 2020, and moved back in residing her primary residence in 2021. She sold the house for $350,000 in 2022. Her profit of $170,000 is not taxable.
Example 2: Ron purchased his home in 2015 for $195,000. The property sold for $465,000 in 2022. He has a tax exclusion of $250,000. The $20,000 gains will be taxed.
Example 3: John and Alice bought their home in May 2008 for $290,000. They sold it in May 2022 for $780,000. Their total gains is less that $500,000, so none of their profit is taxable.
Example 4: Ann and Mark got their house in August 2008 for $350,000 and sold it in August 2022 for $1,150,000. They have a total gain of $800,000. They availed the $500,000 tax exclusion benefits, thus the $300,000 will be taxed at long-term capital gains rates. (If they made valuable improvements, those costs can feasibly be added to the $350,000 purchase price and in effect reduce the taxable income.)
What is the tax impact of turning a primary home into a rental?
Purchasing a new home and moving in, homeowners commonly have two income opportunities for their existing property: to sell or to use it as a rental property. While the idea of receiving passing monthly rental income is appealing, converting your home to a rental can have a consequential tax impact by the time you decide to sell.
Example 5: (from Example 3 scenario) Instead of selling for in May 2022. John and Alice decided to turn their house into a rental. After two years, they no longer want to be landlords and opted to sell their home in May 2024 for $780,000. They still qualify for Section 121 exclusion since they have lived in the home (May 2020-2022) within the past five years. The only income to be reported is the depreciation recapture taken during the rental period.
Example 6: John and Alice continued on renting their home for four years, and sold the property for $780,000 in May 2026. They no longer qualify for the exclusion since they only have resided for one of the past five years. The entire $490,000 profit from the sale will be taxable. There is also a need to recapture any depreciation that was taken during the four years rental.
John and Alice decision in Example 6 has resulted in a higher tax bill compared to when they decided to sell earlier or to sell after only a few years of renting out the property keeping in mind the 2-out-of-5 years home sale exclusion rule.
What approach can I take for real estate that was converted into a rental property?
Owners have the approach below to consider when their homes have been used as rental property:
1. Re-gain exclusion by moving back into the property.
Example 7: Dan and Diane purchased their home in July 2015 for $200,000 and used it as rental a year after. In July 2020, they decided to sell their house. All gains will be included in the taxable income because the home was used as rental for 4 years in the past 5-year period.
They opted to move back in July 2020 and sell it in July 2022 for $600,000. They can now avail the tax benefits because they have used the home as their primary residence for two years of the last five years in the Section 121 exclusion rule.
In July 2022, they had three years qualified use as a personal residence and four years of non-qualified use as a rental home. The $400,000 of profit will be prorated. $400,000 x 43% = $172,000 can be excluded, and $400,000 x 57%=$228,000 cannot be excluded.
Also, all deprecation during the four years as a rental will be part of the taxable income when the house is sold.
The approach to move back into their home for two years allowed Dan and Diane to exclude some of their gains from their ownership period.
2. Continue renting out until qualifying for a Step-Up in Cost Basis
When the owner of an asset dies, that asset is qualified for a complete step-up in cost basis. Any profit that may have been included in taxable income are erased, and the cost basis is "reset."
Example 8: Dan and Diane continued renting out the property. They lived in California and Dan is in critical condition. Dan dies in July 2022 when the house has a value of $600,000. Diane receives a complete step-up in cost basis. The home is treated as if Diane has purchased the house for $600,000. She can sell it as is with no taxable income imposed.
The example above assumes the owners are in a community property state. Otherwise if they are in a common law state, they would possibly not receive a full step-up in cost basis. Owners of rental properties also receive a step-up in any deprecation taken in and included to the capital gains, which gives additional tax benefit.
3. Section 1031 Exchange into a Different Rental Property
If the owner decides to no longer rent out his current property, but still wants to acquire a rental property. The taxpayer can defer taxes with a Section 1031 Exchange. This is a complicated process and it would be best to work with a knowledgeable broker. This approach can only be made between rental properties.
Conclusion
A rental property is appealing particularly if the rent offers a substantial extra income. Profitability is always a key factor to consider along with the desire to be a landlord. Instead of impulsively deciding to turn your primary home into a rental, take into consideration the numbers bearing in mind the home sale tax exclusion rule and the opportunity cost.
If you need help in the computation and professional advice from a landlord and broker, let's discuss it.
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