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ContinueLearn the pros, cons, and tax implications of converting your primary residence to a rental property, plus tips for a smooth transition and maximizing benefits.
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Converting a primary residence into a rental property is a great way to generate additional income and build long-term wealth. However, it’s not quite as simple as buying a second property and keeping the first as a rental. There are insurance, finance, and legal issues, not to mention that operating a rental property is time-consuming and comes with a steep learning curve.
That being said, for some, holding onto an existing home as a rental can be a great financial option, particularly if the home was financed with a long-term mortgage at a favorable interest rate.
In this article, we look at whether it’s possible to rent out your primary residence, the pros and cons of doing so, and the potential tax implications of turning your home into a rental.
Converting your home into an investment property offers several advantages, including:
Renting your home instead of selling can also be a flexible option, allowing you the choice to move back should you need to once the lease term is up.
Let’s break down the above benefits of converting a primary residence into a rental property in more detail.
The tax implications of renting out your home vary depending on factors like location, rental duration, and more. But one thing remains true, while, rental income is taxable and must be reported to the IRS - normally using a Schedule E (Form 1040), you can reduce this taxable income through tax-deductible expenses.
Common deductible expenses for rental properties include:
Related: A Complete Breakdown Of Schedule E Expense Categories
For example, if a rental property generates $24,000 in annual income and the total deductible expenses amount to $18,000, the taxable income would only be $6,000 which is then taxed at your standard income tax rate.
Another advantage of renting out your former residence is the ability to depreciate qualifying assets including the property itself (excluding the cost of the land) over its ‘useful’ life. For residential property this is 27.5 years, and for commercial this is ‘39 years, as outlined in IRS Publication 946.
Depreciation is an expense that accounts for the slow wear and tear of an asset over time and it can be a significant deduction.
To calculate depreciation, start with the cost basis - the original purchase price (minus land), closing costs, and capital improvements, or the home’s fair market value at the time of conversion, whichever is lower.
For instance, if the property’s value is $300,000, with a $25,000 land value, the basis for depreciation would be $275,000. The annual depreciation expense would be calculated as follows:
$275,000 basis / 27.5 years = $10,000 annual depreciation expense
If the rental income after other tax deductions is $6,000 and depreciation is $8,000, the result is a $4,000 loss on paper, creating a passive activity loss (PAL) for that year. This loss amount would be carried forward to the next year (as passive activity losses are not deductible against other forms of income such as W-2 income).
Rental income provides valuable cash flow that diversifies beyond traditional employment. Adding rental property to your portfolio enhances your financial resilience, especially if held long-term, where appreciation and cash flow work together to strengthen your investment returns.
Leverage your rental property income to help pay off your mortgage loans and pay down your debt. This allows you to build equity in multiple appreciating assets, all while taking advantage of the various tax benefits of being a real estate investor.
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Converting a primary residence into a rental property has benefits, however, there are also several tax implications to turning your home into a rental.
As mentioned above, rental income is taxable and needs to be reported at the end of the year on a Schedule E Form 1040 which deals with supplemental income and losses. Additionally, you will need to familiarize yourself with several other new tax forms such as 1099 forms.
On top of this, should you later sell the property after renting it out you may face capital gains tax as well as depreciation recapture.
As a landlord, you need to understand these various tax implications of renting your primary residence and form tax strategies in line with your long-term financial goals.
When a property is converted to a rental, owners can claim depreciation to reduce taxable rental income. However, upon selling, any depreciation claimed must be “recaptured” and taxed as ordinary income, up to a maximum rate of 25%.
For example, if a property was converted five years ago with a depreciable basis of $220,000 (excluding the land value) and accumulated $40,000 in depreciation over those five years, the depreciation recapture tax at 25% would total $10,000.
Any profits on the sale of the property are subject to capital gains tax, calculated at long-term rates of 0%, 15%, or 20% depending on the taxpayer’s income bracket.
If the converted property originally valued at $250,000 sells for $325,000, the gross profit is $75,000. After deducting eligible closing costs, such as commissions, legal fees, and title fees (totaling $16,250 in this example), the taxable gain would be $58,750. If taxed at a 20% rate, the capital gains tax would be $11,750.
The IRS generally classifies rental real estate activities as passive. Importantly, passive losses can only be claimed against passive income. However, passive losses can be carried forward to future tax years if not immediately usable.
For instance, if future rental income exceeds expenses and depreciation, carried-forward PALs can offset future profits, creating a valuable tax advantage over time.
Related: What Does It Mean To Materially Participate In Real Estate?
Rental income is considered passive income, exempt from self-employment taxes like Social Security and Medicare. Typically, self-employed individuals must pay a 15.3% FICA tax, but rental income isn’t subject to this tax. Thus, $50,000 in rental income, for example, would avoid a FICA tax liability of $7,650, boosting your take-home income.
If you lived in the home as your primary residence for at least two out of the five years before selling, you may qualify for the primary residence exclusion for those tax years. This exempts up to $250,000 ($500,000 for married couples filing jointly) from capital gains tax.
Importantly, this is only for the period that you lived in the property. For example, you bought the property for $400,000, lived in it for two years and rented it out for three years afterward, then sold the property for $500,000. This would be a capital gain of $100,000. Because you lived in the property for two of the five years, 40% of that capital gains would be exempt under the primary residence exclusion.
Before we move on from the tax implications of renting out your primary residence, we wanted to quickly cover 1031 exchanges. This is a tax strategy that allows rental property owners to defer both capital gains and depreciation recapture taxes. Investors can sell a rental property and purchase another “like-kind” property, provided they follow specific guidelines:
Multiple 1031 exchanges can be conducted over time, deferring taxes indefinitely. Additionally, if the property is passed on to heirs, the cost basis is “stepped up,” eliminating deferred taxes on capital gains and depreciation recapture and allowing generational wealth to be built.
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While converting your home into a rental property has its perks, there are several challenges that new landlords should anticipate.
Converting a primary residence to a rental property requires time and significant effort. Finding tenants, arranging property showings, screening tenants, drafting leases, coordinating move-ins, and handling routine maintenance and repairs are just a few of the regular tasks that need to be handled when running a rental - there are no shortcuts.
If you live near your property managing it yourself can help you save money - especially if you have quality property management and accounting software like Landlord Studio to help you.
However, if you live further away, out of state or country, or simply don’t have time, you might consider hiring a property management company to handle these duties. This can add to your costs but free up your time and reduce the challenges of direct management.
Related: How Much Do Property Managers Charge? Property Management Fees
While there are some overarching federal laws, like the Fair Housing Act (FHA) and Fair Credit Reporting Act (FCRA), many rental property laws vary from state to state and even from city to city.
Be sure to review local regulations around things like maximum rent increases, security deposits, and eviction laws, and check if your homeowner’s association (HOA) has policies restricting rentals or occupancy by non-owners.
Related: Landlord-Tenant Legal Guides By State
As mentioned above, being a landlord means running a business. A few key taks you should familiarize yourself with include:
Budgeting for rental property expenses is essential to understanding your cash flow potential. Key costs include mortgage, insurance, maintenance, property taxes, legal and administrative fees, and utilities. By creating a preliminary budget that accounts for these expenses along with projected rental income, you can better gauge your expected cash flow in your first year as a landlord.
Once you have your budget and forecast it’s essential that you stay on top of your rental property bookkeeping, tracking every deductible expense, so you can ensure you stay on budget, and maximize your potential revenue.
Rentals are a business and come with various tax strategies, deductions, and liabilities - as outlined above. Understanding these tax implications in detail will allow you to implement an effective tax plan and achieve a profitable return. Otherwise, you could find your plan to generate passive income could get you in trouble with the IRS, or end up with negative cash flow.
It’s always recommended that you talk with a tax professional if you have any concerns.
Related: How Does The IRS Know If I Have Rental Income?
Turning a primary residence into a rental can be a wise choice, but it's essential to follow the right steps. Here’s a seven-step guide to help you transition smoothly:
Related: How to Use HELOC for Investment Properties
Converting your primary residence into a rental property can be a lucrative investment strategy that offers both financial rewards and long-term wealth-building potential. However, it is essential to approach this transition with a clear understanding of the tax benefits and legal responsibilities of being a landlord.
Key advantages include the potential for tax deductions, the ability to depreciate your property, and the opportunity to generate passive income while building equity in a valuable asset. Yet, these benefits come alongside challenges such as managing tenant relationships, maintaining the property, and navigating local regulations.
Utilizing tools like Landlord Studio can help you start off on the right foot. Providing you with a suite of powerful tools that will help you streamline operations and stay organized, so you can run a profitable rental property.
Here are some frequently asked questions from aspiring landlords like you.
Generally, the cost basis is determined by the purchase price of the property, plus any capital improvements made, and any casualty losses claimed for tax purposes. However, cost basis can be complex, so it’s best to consult a licensed CPA who can evaluate your specific situation.
While a common recommendation is to live in your primary residence for at least 12 months before converting it to a rental, there are no strict tax rules on this timeline. Consulting a qualified tax professional can help you evaluate your specific risks and opportunities.
Renting out your home right after purchasing it is generally not typical. However, some lenders may allow exceptions based on specific circumstances.
The market value of the property is usually determined by the lesser of the fair market value or the adjusted cost basis at the time of conversion from primary residence to rental.
Renting out your primary residence has several tax implications, including:
It's crucial to consult a tax professional to navigate these complexities and optimize your tax benefits while remaining compliant with tax laws.
If you decide to revert your rental property back to a primary residence, you will lose eligibility for certain tax deductions, such as those related to repairs. Additionally, when you eventually sell the property, it’s important to understand how this affects your cost basis and capital gains tax. Consulting a licensed CPA can provide clarity on the potential tax consequences.
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