Converting a Residence to Rental Property

For various reasons, including the generally depressed real estate market, homeowners may consider converting their personal residence to rental property. The process for making this decision should include an analysis of economic factors, such as the homeowners’ marginal tax rate and the potential loss of the ability to exclude up to $250,000 ($500,000, if married) of gain from the sale of their principal residence for federal income tax purposes.

Other economic factors to consider include the expected growth rate for rental property in the area, length of time the house will be rented before being sold, cash flow from renting, effect of passive activity rules (which limit and defer tax deductions), and expected rate of return available on other investments. Generally, the economic advantage of converting a personal residence to a rental rather than selling it is increased as the growth rate of the rental property increases and the rate of return on alternative investments decreases. But, each situation should be thoroughly analyzed given its particular facts and circumstances.

If selling a personal residence would result in a nondeductible loss, the homeowner can seriously consider converting the residence to a rental property. Tax savings opportunities generally are limited for residential rental conversions, primarily because of the passive activity loss rules. Converting a personal residence into rental property may allow the homeowner to eventually recognize a loss for tax purposes on the property’s subsequent sale if the property continues to decline in value, but provide cash flow in the interim.

The fact that a residence is rented at the time of the sale does not automatically preclude gain attributable to such use to be excluded under the gain exclusion rules. Instead, the exclusion of gain depends on whether the homeowner meets the ownership and use requirements and the one-sale-in-two-years test at the time of the sale. In all cases, however, gain exclusion cannot be claimed to the extent of depreciation adjustments attributable to periods after May 6, 1997.