Emily has had her house on the market for over a year and has yet to receive a good offer, so she has decided to rent out the property.
Task number one for Emily is to consider taxes. As owner, she will report her rental income and expenses on her personal income tax return. Expenses such as advertising, maintenance, insurance, mortgage interest, real estate taxes, repairs, and utilities are deductible.
So is depreciation. But the depreciation period for residential rental property is 27.5 years. If Emily’s rental property shows a tax loss for the year because of depreciation, the tax law’s “passive activity” rules generally take effect. If she actively participates in her rental business, she potentially can claim a loss of up to $25,000 against non-passive income (such as wages). The $25,000 loss allowance phases out with adjusted gross income between $100,000 and $150,000.
When Emily does sell the house, she may be eligible to exclude up to $250,000 ($500,000 on a joint return) of capital gain for tax purposes — but only if the rental activity was temporary and the sale took place while she still met the tax law’s ownership and use tests. Even then, gain is taxable to the extent of any depreciation that was (or could have been) claimed on the property. In contrast, if Emily sells her property at a loss, she can deduct the loss only if she proves that her former home’s conversion into a rental property was meant to be permanent.
Renting out a former residence in a tough real estate market may be a viable option. However, taxpayers should consider the potential tax effects before making a decision.
Client Profile is based on a hypothetical situation. The solutions we discuss may or may not be appropriate for you.
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