Tax Issues of Converting Your Residence into a Rental Property

IRS, Taxes

Whether you need something bigger for a growing family, you’re balling and you want to just want bigger and fancier digs, or for whatever reason, you’ve decided it’s time for a new house. Maybe you’re in the fortunate position where you made a few extra stacks and you don’t necessarily need to sell your current house in order to buy a new or “another” one. Yes, another one. Keeping your current residence and using it as a rental offers the obvious benefits of cash flow and retirement investment. But, the simple maneuver of converting your personal residence to a rental property also brings with it many tax rules, mostly good when you know how they work.

Once you’ve converted a former personal residence into a rental, you must follow the tax rules for landlords. And here is where a lot of the tax benefits kick in. You can deduct mortgage interest and property taxes on a rental property. You can also write off all the standard operating expsenes that go along with owning a rental property: utilities, (if you pay them) insurance, repairs, maintenance, yard care, association fees and there could be others. You can also depreciate the cost of a residential building over 27.5 years, while in reality it’s appreciating.

Another nice thing: positive taxable income from rental real estate is not hit with the dreaded self-employment (SE) tax, which applies to most other unincorporated profit-making ventures. The SE tax rate can be up to 15.3 percent, so it’s a wonderful thing when you don’t have to pay it.

And the hits just keep on coming! Another good thing is that your net rental profits may qualify for the Section 199A deduction. What’s this you ask? When you sell a rental property that you’ve owned for more than one year, the profit (the difference between the net sales proceeds and the tax basis of the property after subtracting depreciation deductions during the rental period) is generally treated as a long-term capital gain. Always keep in mind the good news here. You don’t pay the taxes on the property appreciation until you sell, and the gains, are tax-favored capital gains.

And always keep this in mind, rental real estate owners can avoid taxes indefinitely using Section 1031 exchanges, so-named after the applicable section of our beloved IRS Code. The tax code totally mislabeled the 1031 exchange. It’s absolutely not an exchange or a swap. You can sell your property, buy a new pricier one and your “section 1031 exchange intermediary, also known as a bank, handles the paperwork and all those nasty cap-gains taxes are stuffed into a can that is kicked way down the road.

For sure, rental property is not all rainbows and unicorns. There will be late calls for expensive repairs and sometimes you have chase down people for rent. But there are reasons there are millions of millionaires from rental real estate. One of those reasons is the tax advantage that helps you hold on to more of your money.

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