Tax Reasons to Turn Your Primary Residence into a Rental | USTaxAid

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Tax Reasons to Turn Your Primary Residence into a Rental

Written by Diane Kennedy, CPA on October 26, 2022

If you spend any time looking on the Internet for real estate tax saving strategies, at some point you are bound to run into someone who says you should move into your rental to get a capital gains exclusion.

That was a great strategy. Over 13 years ago! In 2009, the IRS gave us new rules on turning a rental into a primary residence. Here’s how it works.

Capital Gains Exclusion When You Sell Your Primary Residence

 

The IRS allows you to take a capital gains exclusion of $250K/$500K (single or married filing jointly) when you sell your primary residence that you lived in for 2 out of the previous 5 years. There are some other things that you may need to consider such as the need to recapture depreciation (i.e., pay tax on it) or attribute gain to a rental period if there was mixed use. Other tax confusion occurs when the taxpayer goes through a divorce or has a new marriage.

 

Where is your Primary Residence for the Capital Gains Exclusion?

 

Vacation Homes, Rental Homes, Primary Residences and the Capital Gains Exclusion

Today, we’re going to look at two very specific tax strategies that you may consider if you’re in the same situation.

Your Home Has Gone Down in Value

Real estate values are dropping in many parts of the country now. If you need to sell now and it will mean a loss, is there any way to take advantage of that loss on your tax return?

No.

Primary home capital losses are not deductible. However, rental home losses are deductible.

But what if you turn your house into a rental before you sell? If you do that (and of course, make the change legitimately), then the loss upon the sale will be deductible against your other income. If the loss is more than your income that year, you can roll the loss forward.

This is NOT a capital loss, like you have with stock when you sell. In other words, you aren’t limited to just $3,000 per year in loss deduction like you get with the sale of stock. The loss upon the sale of a rental property will be a loss you can take against other income.

The biggest challenge with this strategy is waiting the 1-2 years with your property as a rental before you sell. That means you need to move out and find another place to live. You need to rent out your previous home, collect rent, make repairs and continue to pay the bills.

And you need to wait.

If the market recovers in that time or your situation changes, you can move back into your house. Since the property started out as a personal residence, you won’t need to apportion gain to the time it was a rental. All the gain will be subject to the capital gain exclusion in that case, as long as you can show you lived in it for 2 of the previous 5 years.

Your House Needs Updating

This is an interesting strategy that came up during one of our Wednesday Coaching classes. These are held the 1st – 4th Wednesday at 5 pm Pacific. Although we have Home Study Courses for most of the classes, we cover a whole range of other tax, asset protection and strategies to increase cash flow and wealth. It all depends on what you want to talk about! You can join live and ask your questions during the call or send a note to Coaching@USTaxAid.com before the class.

The strategy had to do with a home that needed updating. If you spend money on your primary residence, it will increase the basis. In most cases, there isn’t a lot of tax benefit to that, though because you will likely get a capital gain exclusion for most of the gain. More basis does not really matter.

But if you have a rental property, those expenses can either be home improvements or repair expenses. The repair expenses will reduce your current income. Improvements need to be capitalized and then depreciated. When you sell the property, you need to recapture and pay tax on the previously deducted depreciation. You don’t need to recapture expenses you deducted in the past.

There are two parts to this strategy. First, you need to move out of your house and rent it out. It needs to be “in service” before you start remodeling. If you wait to rent it and instead start the repairs first, you will have to capitalize the expenses. And that means depreciation and recapture of that deduction.

So, move out, rent it out and then rehab.

And then make sure you’ve used strategies to expense out the costs instead of needing to capitalize and depreciate.

Wait a couple of years. Move back into the house and stay another year or so to qualify for 2 of the previous 5-year deadline.

If everything works out and you follow the template (rent, rehab, expense, move back in, sell), you can take a deduction for the updates.

Does that mean that everyone can do this? Absolutely not. Tax strategies like this take years to put together and you must follow the guidelines.

When it comes to taxes, the more you know, the more you save.

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