There are a number of potentially important tax consequences of renting your house. The most important matter to consider before deciding whether to rent it out is whether you risk losing the ability to roll over the gain on the eventual sale of your house into a replacement house. If you could lose that benefit, don`t rent.
The tax laws provide a very favorable tax break for homeowners that you probably don`t want to risk losing. When you sell your principal residence, if you buy a replacement principal residence within two years that is at least as expensive as the house you sold, you can defer paying any tax on the sale. There is a condition, however. To qualify for this great tax break, the house you sell and the house you buy both must be used as your principal residence. The potential risk with renting your old house before you sell is that you will change its character from being your principal residence to being a rental property in Internal Revenue Service terms. And a rental property can`t qualify for the tax-free rollover. The IRS will claim that you abandoned the house as your principal residence if you rented it for an extended period. However, the courts have permitted taxpayers to temporarily rent a house while trying to sell it.
Making your case
But what is temporary? There are no exact guidelines as to what you can and can`t do. The following list of suggestions will support your case that the house you rented out should still qualify for tax-free rollover treatment: – Rent for as short a term as possible.
– Reserve the right in the lease to show the house to prospective buyers. – Keep advertising the house for sale throughout the rental period.
– Include an option to buy in the lease.
– Sell the house (and buy your replacement house) within two years of moving out.
Once you`ve determined that the rental won`t ruin your ability to roll over the gain on your house, you can then consider the tax effects of the rental itself. If you rent your house with the intent of earning a profit, you can deduct expenses that you pay against the rental income you realize. Expenses include all ordinary and necessary business expenses: insurance;
property taxes (but not special assessments); maintenance and repairs (but not capital improvements that add to the value of the house); accounting, legal and other professional fees; and depreciation.
Depreciation is calculated by dividing your investment in the house
(adjusted tax basis) by 27.5 years. Here is a definition of ”adjusted tax basis”: the price you paid for the house including all of the ancillary closing costs, plus any capital improvements you made (such as a new roof or porch), minus any losses from fire or other casualty and any depreciation deductions already claimed (such as on a home office you maintained in the house).
Passive loss rules
With the deduction for depreciation, you can have a loss for tax purposes, or no gain, while still having a positive cash flow. If you realize a loss on renting your house, you must satisfy a number of requirements in order to claim that loss for tax purposes. The most important are the passive loss limitations rules.
These rules say you cannot apply losses realized on a rental real estate investment (like your rental house) to offset other income (wages, dividends, interest) and reduce the tax due. However, there is one very important exception to this rule that many people will qualify for. Under certain conditions, you can deduct up to $25,000 in tax losses from certain rental properties without any limitation by the passive loss rules. The conditions are that (1) your modified adjusted gross income (your income on your tax return before deducting itemized deductions, subject to a number of adjustments-it will simply be referred to as income in the following discussion) must not be more than $150,000, and (2) you must actively participate in the leasing of the property.
This benefit is actually phased out as your income rises from $100,000 to $150,000: If your income is $100,000, you can use up to the full $25,000 of tax losses; if your income is $125,000, you can claim up to $12,500 in tax losses; once your income reaches the $150,000 mark, you will only be able to use the tax losses on your rental property to offset income you earn on other rental properties or other passive investments.
When a purchase option is included in the lease agreement, depending on how the arrangement is structured, there is a risk that the IRS will say that instead of leasing, you really sold the property immediately on the installment method. The IRS is most likely to make this claim when it is obvious that the tenant will exercise the option.
Clarify your intentions
In less extreme situations, it can be unclear whether the IRS will respect the transaction as a lease-option arrangement or choose to treat it as a sale. To avoid a problem, consider the following points:
– The higher the percentage of the monthly rent that is credited toward the purchase price, the more it will look like a sale. Crediting 10 percent of the rent shouldn`t create much problem. Crediting 75 percent will almost assuredly result in a sale treatment.
– If title to the house transfers to the ”tenant” when the ”lease” is signed, the transaction will be considered a sale. You wouldn`t want this to happen anyway unless you had a mortgage or other legal documentation to protect your interests.
– The monthly payments by the tenant shouldn`t exceed the fair rental value of the house by a significant amount.
– The purchase option shouldn`t be much less than the property`s fair market value.
– The tenant shouldn`t be required to make substantial improvements to the house. If the tenant had to invest substantial money, it would be obvious that the tenant would exercise the option.
