Tax Implications of Converting Your Primary Residence to a Rental Property
With the housing market being as it is, it has never been more profitable to rent out your place. This is the main reason why you might want to be considering converting your primary residence to a rental property if you can manage it. However, the tax code that governs such a transition is quite complicated, so you might want to type in a Google search for the best tax relief companies near me before you proceed. But before you do that, you might want to learn a few tax implications of such a venture. And that is precisely what we are going to cover in this article. We will provide you with all the information you might need to get started. Without further ado, let’s get right in!
Tax implications of converting your primary residence to a rental property
There are four main factors that you may want to consider. They are:
- Tax deductions
- Self-employment tax
- Passive activity loss
Before we go into an in-depth explanation of each of these factors, it is important to note that the exact tax procedure varies from one rental to another. Therefore, it is usually in your best interest to hire a professional tax consultant who can explain everything in detail. All the information in this article is of a general nature and may not apply fully to your particular situation. The U.S. tax code is incredibly complicated, and covering all possible situations is virtually impossible. That being said, you also want to learn as much as you can on your own about the various tax implications that converting your primary residence implies. And the best place to start is with tax deductions.
Tax deductions associated with converting your primary residence to a rental property
Rental properties are allowed numerous tax deductions. Most notably, you can claim deductions for depreciation, something that you can’t do with your primary residence. Other notable rental property deductions include:
- Mortgage interest
- Property taxes
- Association fees
- Legal fees
- Management fees
Basically, you can use almost all the deductions that are available to a business since your rental property is basically a business. Furthermore, if you plan on utilizing a service such as Airbnb, know that there are additional tax rules for Airbnb rentals. These tax deductions will offset the income you get from your rental property, and you can also make allowable deductions on your income taxes. To illustrate this point, imagine that your new rental property makes $50,000 in gross rental income. If your expenses for that time period were $40,000, your net income would be $10,000.
Avoiding self-employment tax
By converting your primary residence to a rental property, you are also capable of completely avoiding the FICA (payroll) tax, also known as the self-employment tax. You would normally need to pay a hefty %15.3 tax for your Medicare and Social security on any income you earn during the tax year. But the “catch” here is that you are not actually actively earning income with your rental property. The income that the rental property generates is classified as passive income instead.
However, there are exceptions. This is the part that can get very complicated. While you may be able to use most of the popular tax deductions for businesses and avoid the self-employment tax at the same time, there are situations where you will be unable to do so. Therefore, the best thing to do is to contact a tax professional and have them figure out what exactly applies to your situation and what does not.
Passive activity loss and how it relates to converting your primary residence to a rental property
Passive income is regulated by PAL (Passive Activity Loss) rules. Your property can be considered to generate passive income even if you participate in its management. Under these rules, you can’t claim deductions that exceed the total passive income generated. This is quite important for people that have multiple passive income sources. Furthermore, these rules do not apply if the investor’s AGI (Adjusted Gross Income) is lower than $100,000.
So, why is passive activity loss so important when it comes to rental property, you may ask? This is because you can carry forward unused (or disallowed) passive losses to the next year. This may help you boost your tax refund amount in the years when your rental property generates more income, as that income will be offset by the previous years’ losses.
The last tax implication is that you can now depreciate your property. The depreciation for rentals is carried over a period of 27 and a half years, and it represents the general wear and tear, deterioration, or obsolescence of the rental property. This is all covered under IRS Publication 946. This particular publication is a very important read, and it is in your best interest to learn as much as you can from it.
To save you some time, here are the most important points:
- Depreciation applies only to the building itself and not the land it is on
- The cost basis for depreciation is either the home’s purchase price (adding any qualified improvements to the price) or the home’s fair market value at the time of its conversion.
- You get the annual depreciation expense by dividing the basis by 27.5 years.
While this may sound quite easy to understand, it is important to note that the calculation itself can get rather complicated. However, the IRS will provide you with depreciation tables to make it easier. But the fact of the matter is that you may still need a tax professional. Otherwise, making heads or tails of the whole situation may be difficult.
To find the best tax professionals to help you with converting your primary residence to a rental property, refer to Consumer Opinion Guide. We also have other tax-related articles that may be of further help. The more you know, the easier it will be to proceed with the conversion!