Article Highlights: Reason for Conversion Basis Depreciation Cash Flow versus Tax Profit or Loss Passive Losses Home Gain Exclusion Other Tax Issues Becoming a Landlord With the current substantial appreciation in home values and demand for housing exceeding the available inventory, along with low home mortgage interest rates, more and more homeowners are converting their existing homes into rentals when they buy a new home. Other reasons individuals may make the conversion include maximizing the tax benefits for an elderly person who can no longer live alone by delaying the sale of that person’s home; and to ensure that a home provides value when its owner takes a temporary job assignment in a different location. Some homeowners even mistakenly think that, when a home has declined in value, converting it into a rental can allow them to deduct that loss. Regardless of why an individual considers making a conversion, several tax matters come into play when making that decision. Basis – The basis of the converted property is a good place to start examining these conversion-related tax issues. The basis is the starting value that is used to calculate gains or losses for tax purposes. The basis is also used to determine the amount of depreciation that can be claimed for property used in the rental activity. Generally, for depreciation purposes, a property’s depreciable basis on the date of the conversion is the lower of its adjusted basis (the original cost, plus the costs of any improvements, minus any deducted casualty losses) or its fair market value (FMV). Example #1: A home’s original purchase cost was $250,000; the homeowner later added a room at a cost of $50,000. At the time of the conversion, there had been no casualty losses, so the home’s adjusted basis is $300,000 ($250,000 + $50,000). By comparison, the property’s FMV is $350,000, so the depreciable basis for the rental is the lower of the two amounts: $300,000. Example #2: If, on the date of the conversion, a home has the same adjusted basis as in Example #1, but its FMV is only $225,000, then the depreciable basis used for the rental is equal to $225,000, as that is the lower of the two amounts. When a home’s FMV is less than its adjusted basis on the date of conversion, as in Example #2, the rental has dual bases: (1) If the rental is subsequently sold for a loss, the basis for loss is the FMV on the date of the home’s conversion. Because losses from the sale of personal-use properties (such as homes) are not deductible, this rule prevents homeowners whose homes have declined in value from converting them into rentals in order to claim tax losses. (2) If the rental home is subsequently sold for a profit, the basis for the gain is the property’s adjusted basis. Depreciation – Depreciation is an allowance that both accounts for wear and tear and provides a systematic way for the owner to recover the initial investment in the property. This is necessary because tax law doesn’t allow homeowners to deduct the entire cost of a residential rental at one time. Despite this statutory allowance for the depreciation of residential rentals, real properties have historically appreciated rather than depreciated, so this allowance typically provides a significant tax advantage (i.e., a write-off). Here is how to determine the depreciation for a residential rental: First, reduce the basis by the value of the surrounding land (as land is not depreciable) to get the value of the improvements to the home (i.e., the structure); then, multiply that value by .03636 (the annual depreciation rate). In the conversion year, the resulting amount has to be prorated by the number of months used as a rental. Generally, the value of the land is based on a property-tax statement. For example, if a property-tax statement values an entire property at $240,000 and its land at $80,000, then 1/3 of the basis ($80,000 / $240,000) is allocated to land; the remaining 2/3 is allocated to improvements. Thus, if the basis is $300,000, then the depreciable improvements are valued at $200,000 (2/3 × $300,000), and the annual depreciation deduction is $7,272 (.03636 × $200,000). Rental Cash Flow versus Taxable Profit or Loss – Cash flow is the net amount after subtracting expenses from rental income, and the taxable profit or loss is the rental income minus any allowable tax deductions. Of course, higher cash flow is always better, but it is particularly important to avoid having a rental with a negative cash flow. The following example compares cash flow to taxable income. COMPARISON OF CASH FLOW AND TAXABLE INCOME Income/Expense Cash Flow ($) Taxable Income ($) Rental Income 30,000 30,000 Mortgage Payment <23,000> Mortgage Interest <20,700> Real Property Tax <2,400><2,400> Insurance <1,800><1,800> Maintenance & Repairs <400><400> Gardening <800><800> Depreciation <7,272> Total Expenses <28,400><33,372> Cash Flow 1,600 Taxable Income <3,372>