Renting your Home

Renting out your home can be a smart way to generate income, but it also comes with tax consequences that must be carefully considered. While the rules can be complex, here are 3 key tax considerations when trying to decide whether to rent.

1. Capital Gains Exclusion

One of the biggest tax benefits of home ownership is capital gain exclusion when you sell your primary residence.  If you have owned your home for many years and it has increased in value, selling the home could result in a gain that is subject to taxation. However, under Code Section 121 homeowners can exclude up to $250,000 ($500,000 for married couples filing jointly) of that gain.  But, there are important “use” tests to qualify for this exclusion.  Critically, you must live in the home for at least 2 of the 5 years prior to sale.  So, if you are planning to rent out your home and travel or rent out your home while you shop for a new home in another state, beware. If you wait too long you could be setting yourself up for a big tax bill on sale.  You typically have a three-year window to sell and still qualify under the use test. Still, even if you qualify for the exclusion, the exclusion is reduced for the time that you rented the property.

2. Taxation of Rental Income

Rental income is typically tax efficient, but it is still taxable income.  You can deduct any expenses, including mortgage interest, property taxes, insurance, repairs, maintenance, and utilities.  You can also deduct depreciation, which allows you to recover the cost of the home over 27.5 years.  However, any rent payments in excess of costs will be taxable income. It is important to keep good records including costs to upgrade the property since this will help reduce your taxable income from rent.

3. Depreciation Recapture

Depreciation is an important deduction when you are renting out your property, but under IRS rules it also creates a future tax obligation called depreciation recapture. Basically, when you sell your property the IRS requires you to pay taxes on the depreciation you claimed.  This means that even if you qualify for the capital gains exclusion, the portion of the gain associated with depreciation cannot be excluded. Importantly, the IRS can subject you to depreciation recapture even if you did not actually claim the depreciation, so you do not have to option to ‘opt-out’ of the depreciation and depreciation recapture rules.

What should you do?

Renting out your home involves more than just collecting rent.  It involves more than just finding a good tenant and managing the property.  It requires important tax planning. Hopefully, these basic concepts will help you get started but also talk with your tax advisor. Depending on your situation, it may or may not be a good idea to rent out your home. In any event, it is important to avoid any unexpected taxes if you eventually sell.