For many, being in the position to either sell your primary residence or rent the property is a powerful one. Rental income can be a great additional source of income and the investment, if managed properly against the rest of one’s financial portfolio, can contribute to a nice tax shelter.
Buying your home with the mindset of becoming an investor is a very intuitive and proactive wealth-building strategy. By living in the home for the first few years, you will have the advantage of securing premium financing terms, including competitive interest rates and low down-payment requirements.
Keep in mind, however, if you obtain a lower-rate mortgage under the conditions of being an owner-occupant, then it is important that you actually live in the home for the duration of the term conditions and not rent the property at the outset.
Why?
If your lender discovers you never lived in the property, purposely lived there for a short duration, or that the property is being rented out, you may be charged with mortgage fraud and possibly forced to pay the mortgage balance in full.
The smart investor will pay the dues of living in the property first to reap the full advantage down the road.
Knowing this, let us look at a couple of the tax considerations when converting your property from a primary residence to a rental property:
Know the basis of the property.
The basis of the property is what you have invested into the property from a cash perspective against the value of the property. A few points to know:
- How much did you pay to purchase the property and what was the source of funds?
- Did you use your own money?
- Did you receive the property as an inheritance?
- How much did you spend for improvements when you purchased the property?
Knowing the answers to these questions are important as the conversion creates a tax issue. When one converts a property from a personal residence to a rental property, it is not a matter of simply taking the basis as the ‘new’ basis. Factors such as conversion date and how long the property has been held come into consideration. The fair market value at the conversion date might be the most important factor when determining the tax outcome of a sale at a later date. A bank appraisal or a written fair market value, prepared by a licensed realtor and signed by a Notary, should suffice.
Keep in mind, an ‘issue’ may not necessarily be a bad issue, but rather, a reduced tax basis that one can depreciate as a rental.
Benefits of converting:
- Some choose to convert their primary residence to a rental if the value of the house has depreciated but do not want to sell because the market is soft and instead, wait out the market rebound. This creates additional cash flow from rental income that will offset the costs of holding the property.
- Many times, rentals will have a loss but the owner will see positive cash flow because depreciation is a noncash item.
- If you lived in the house two of the preceding five years, you will not pick up the gain (if there is a gain) when the property sells. This can save quite a bit in taxes.
- If you are claiming a personal residence, any loss resulting from the sale will be non—deductible for income tax purposes.
- Positive cash flow will equal a loss on your tax return, which creates lower income and as a result, less income tax owed.
What if the property requires many significant improvements before it can be used as a rental? Keep in mind those improvements will affect your basis. We advise folks to meet with their tax advisor as no two situations are alike, especially when considering the effect on the basis and depreciation.
If you have questions about converting your primary residence to a rental or any other tax, accounting, or business management concerns, contact me at Rhuszai@zinnerco.com or any of our tax professionals at 216.831.0733 or via email at info@zinnerco.com. We are happy to help and ready to start the conversation. 
