Tax Considerations of Converting Your Primary Residence into a Rental Property

Posted on Thu, Oct 18, 2018 ©2021 Drucker & Scaccetti

D&S - 2016-Web_090-1By: Clare Porreca, CPA, MT


Converting a primary residence into a rental property is a common occurrence.  With the real estate market on a slight decline, more taxpayers may decide to rent rather than sell their homes to wait out the market.  If you’re in this situation, read on so you’re aware of the tax implications of converting your home into a rental property.


Tax Reporting

The income and expenses related to the rental property will be reported on Schedule E of your tax return.  You can deduct most expenses related to the property: mortgage interest, real estate taxes, repairs, maintenance, cleaning, insurance, depreciation, etc.  When calculating depreciation on a rental property converted from a primary residence, the basis of the property to depreciate is the lower of the adjusted basis or the fair market value on the date of conversion.  Getting an appraisal is the best method to document the fair market value.


Deductibility of Rental Losses

Unless you meet specific tests to qualify as a “real estate professional” for tax purposes, any losses from the rental will be treated as passive losses.  Passive losses are not deductible on your tax return unless you have passive income from other sources.  If you do not have any passive income, the rental losses will be “suspended” until a year in which you have passive income or the year in which you dispose of your rental property.  Converting the property from the rental back to your primary residence does not qualify as “disposing of the property.”  Thus, the losses you incur each year, relative to your rental property, will most likely not yield a tax benefit until you sell the house.   


There is an exception to this rule for certain taxpayers who “materially participate” in the rental activity and have modified adjusted gross income of less than $150,000 (for married taxpayers) to deduct up to $25,000 of rental losses each year.  Because of the low-income thresholds; however, this exception does not often apply. 


Exclusion of the Gain on Sale of Property

For married taxpayers, up to $500,000 of gain can be excluded from taxable income on the sale of a property that was used as a principal residence for at least two of the five years before the sale.  If the value of your home has appreciated and you think you may want to sell it soon, plan to meet this exclusion.  You don’t want to be stuck with a gain on the sale of the property because you missed the exclusion by a few months.


Other Considerations

  • Local jurisdiction taxation and business requirements: For example, as a landlord for a property in Philadelphia, you’ll need to apply for a Commercial Activity License and a Business Tax Account.  You’ll then need to file both the Business Income & Receipts Tax Return and the Net Profits Tax Return each year. 


  • Record keeping: make sure you create some method for tracking your rental income and losses. Whether it is as sophisticated as using QuickBooks or as simple as putting all the checks/receipts in a folder, you’ll want to have some way to document everything.


  • Landlord insurance: while not a tax-specific item, don’t forget to get landlord insurance! While we all hope for clean and respectful tenants, you don’t want to be caught with the wrong type of coverage.


If you’re considering converting your primary residence into a rental property, call on The Tax Warriors® at Drucker & Scaccetti.  There could be other considerations specific to your situation we can discuss with you.  


Topics: real estate, Primary Residence, mortgage interest, Depreciation, Rental property, appraisal, Real Estate Taxes, Schedule E, passive losses, passive income, Commercial Activity License, Business Tax Account

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