Table of Contents
5 Benefits of Converting a Primary Residence to a Rental Property
1. Generate Rental Income Until Housing Market Improves
You may have found yourself in a situation in which the potential sale price of your current home is not satisfactory. At the same time, your next “dream” home may be available for purchase at a price you’re very interested in. Assuming your finances are in order and you can afford to purchase the new home, converting your current home into a rental property may be a viable option. If your local markets rental prices are enough to represent a profit on your current home, you could choose to rent your home out and wait for the market value of the home to increase.
2. Tax Deductions
The IRS requires income from a rental property to be reported using Schedule E (Form 1040). However, the amount of income subject to taxation is the net income after all tax deductions and expenses available to you as a landlord have been claimed. Some common expense deductions include:
- Advertising(such as listing the property available to rent and finding tenants)
- Cleaning and maintenance
- Insurance(includes homeowners insurance and landlord liability insurance)
- Management fees
- Mortgage interest
- Taxes(such as property tax)
- Legal fees
- Commissions(like those paid to companies like Ziprent who help find you qualified tenants)
These costs help reduce your overall net income from the property. Imagine over the course of a year the property is netting you $30,000 in annual gross income. If you tally up all your expenses that total $20,000, your taxable income is only $10,000.
3. Depreciation Expense
A key benefit of turning your primary residence into an investment property is being able to depreciate the property over a period of 27.5 years. What exactly does this mean? IRS Publication 946 explains that depreciation is simply an expense allowance for the wear and tear or deterioration of the property. It’s important to understand depreciation applies only to the building and not the land.
For example, if a home is valued at $300,000 and the value of the lot is $20,000, the value for depreciation purposes would be $280,000. Calculating the annual depreciation expense is relatively simple by dividing the value by 27.5 years.
- $280,000 value for depreciation / 27.5 years = $10,181
When a primary residence is converted into a rental property, the owner can then deduct the depreciation expense from the income the property generates to effectively reduce taxable income.
4. Passive Activity Loss (PAL)
In general, the IRS considers rental real estate activity to be a passive activity. Even if an investor participates physically, such as visiting the property and meeting with a property manager for example. Under the PAL guidelines, an owner cannot claim deductions that would exceed the amount of income received from the rental property. There is a small disclaimer to this as claimed deductions can exceed rental income if the owner’s gross income is less than $100,000.
Don’t worry though, passive activity loss doesn’t have to go to waste. Should that passive activity loss exceed the income generated from a rental property, you can pass that unused PAL to the next taxable year to offset passive activity profits. Be cautious with topics like this and always enlist the help of a tax professional when needed.
5. Avoiding Self-Employment Tax
Also known as FICA or payroll tax, self-employment tax requires taxpayers to pay a 15.3% tax for Social Security and Medicare on any income earned. However, because a rental property is treated as passive income instead of earned income, there is often no self-employment tax due.
For example, imagine a taxpayer earns $100,00 in self-employment income. The tax(15.3%) would equal $15,300. If a real estate investor earned the same $100,000 in income from rental properties, there would be $0 in FICA tax due.
2 Drawbacks to Converting a Primary Residence to a Rental Property
While the benefits of converting a personal residence into a rental property are clear to see from the above, there are some drawbacks to consider. Let’s briefly cover them below and then get into some steps for converting your current home into a rental property.
1. Depreciation Recapture Tax
What happens if you eventually sell your rental property? Unfortunately, some of the tax benefits we discussed above can have repercussions on tax liability once the property is sold. Typically the owner of a primary residence can exclude up to $250,000 of any sales gains from taxation, or up to $500,000 in gains if married and filing jointly. However, capital gains on rental properties work differently.
In #3 of the 5 tax benefits, we discussed a depreciation expense of $10,181 per year. Let’s assume that the property was used as a rental property for 5 years, for a total depreciation expense of $50,905 claimed. The depreciation expense used to reduce taxable net income is recaptured and taxed as ordinary income, up to a maximum rate of 25%.
$50,905 claimed x 25% maximum taxable rate = $12,726.25.
2. Capital Gains Tax
As is common with most investments, a capital gains tax can be assessed once that asset has been sold, assuming a profit has been made. Any profits on the sale of the property are taxed using the long-term capital gains tax rate of 0%, 15%, or 20%, depending on the owner’s federal income tax bracket.
You can reduce your tax liability through deductible closing costs, such as sales commissions. There is one exception here, in which the owner has owned the property for at least 5 years but sells within 2 years of turning the property into a rental. Consult the help of a tax professional to maximize your deductible closing costs, thus reducing your overall tax liability from the sale.
6 Steps to Converting Your Home Into a Rental Property
Whew, all that tax stuff was a bit of a mouthful huh? The below will be a little more straightforward, ensuring the foundations are in place to become a successful and profitable landlord.
1. Get landlord insurance
Homeowners insurance is still important, but it won’t be enough if you decide to convert your home into a rental property. You’ll want landlord insurance that can help protect you against a whole host of potential liabilities. Landlord insurance can protect you against standard risks like damage from natural disasters, but it will also protect you from liability if a tenant or a guest of a tenant is injured on the property. There are even additional things like protection against missed rent payments that landlord insurance can provide.
2. Complete Repairs & Upgrades
This step can become costly if not done with a level head. You’ll want to make sure that at a bare minimum, your rental property is up to code before you start a lease with a tenant. Once that’s in place, you can also look into what upgrades might net the best return on the property. Unless you’re looking for a specific high-end clientele, you don’t need to go overboard with this.
First impressions are everything. Making sure the landscaping is in order, the house is truly clean during showings and everything mechanical is in working order can go a long way to attracting quality tenants. If you have a budget set aside for serious renovations, you can look into ways to add rooms to increase the overall rental value of the property. Does your property include the amenities expected from the area? All of these can be important to maximizing the potential cash flow from your rental property.
3. Decide How Much to Charge
This is an area where it may be wise to hire a property management company like Ziprent to help. We have access to thousands of properties in your area and data to help ascertain the fair market value of your property. In fact, we offer a market analysis of your rental property free of charge as part of our process. Maximizing cash flow from your property is of course important, but you’ll also want to make sure the rent amount aligns with the surrounding market.
If you choose not to use a property management company, you can look at various rental sites like Zillow, Craigslist, or Apartments.com and compare how much similar units are going for. You can also keep tabs long-term to see how long rental units are staying on the market.
4. Learn the Laws
Housing laws are complex and you certainly don’t want to end up on the wrong side of a fair housing lawsuit. You’ll need to fully understand what keeping your property up to code entails, as well as the laws around fair housing and tenant rights. Not knowing all of this can put your business in jeopardy which is why it is wise to at least consult a legal professional before starting your business as well as if you plan on making any big decisions down the road just in case.
Some other steps to consider:
- Check with the lender to see if the existing mortgage can be used for rental property instead of a primary residence.
- Research options for investment property loans if the home will need to be refinanced as a rental property.
- Notify your insurance agent that the home will be used as a rental property and add the landlord liability insurance policy.
- Make sure the homeowner association (HOA) will allow the home to be used as a rental.
- Apply for any necessary permits and licenses, since some cities and states require a landlord to collect and remit a rental or sales tax.
FAQs: Converting Your Home to a Rental Property
How long do you have to live in the house before you can rent?
This can depend entirely on your lender. It’s best to check with both your lender and in some cases the local laws to make sure you’re in compliance.
Does your mortgage change if you rent?
You may not have to change your mortgage if it already allows for conversion to a rental property. If it’s not allowed under your current mortgage arrangement, you should ask your lender about refinancing an investment property loan.
How do I convert my mortgage to a rental property?
If you are a property owner with a mortgage, it is possible you can convert that mortgage to a rental property. This will allow you to continue to own the property while generating income from tenants. Start by calling your lender and finding out if there are any restrictions with your current mortgage. You will need to create a rental agreement and submit it to your lender typically, but they will be able to fill you in on the specifics. You’ll likely be asked to submit a rental property budget detailing that you are able to cover the mortgage payments, property taxes, and other associated costs.
What are the tax consequences of converting my property?
This can depend on a variety of factors. This includes the amount of time a property was used for rental purposes and the amount of depreciation that was claimed on the property. As we discussed above, any depreciation that was taken on the property will need to be recaptured when the property is converted to personal use. In addition, any rental income that was earned on the property will need to be reported as income on the taxpayer’s personal tax return.
How do you turn a residential home into a commercial property?
If you aren’t interested in converting to a rental property, commercial property is also an option. However, this comes with its own unique challenges. The first step is to change the use of the property. This can be done by contacting your local council and informing them of your plans. The council will then send you a form to fill out that outlines the changes you are making to the property to turn it into a commercial property. These changes will of course have to be compliant with all local laws and regulations. If an inspector approves the changes, that same council will issue you a certificate for change of use. Once that certificate is in hand, you’re free to start advertising your commercial property for its intended use.
Can my rental property be my primary residence?
It’s hard to provide a definitive answer to this question as it will depend on the specific circumstances of each case. In some cases, it may be possible for a rental property to be treated as a principal residence for tax purposes. You should speak to a tax professional and explain why you are pursuing this route.