04 Jan Renting Out Your Home?
Real Estate is one of the oldest paths to wealth accumulation. Just ask Augustus Caesar. Unfortunately, you can’t just take people’s land (for the most part) these days. Mr. Caesar also didn’t have to deal with the IRS. Nonetheless, becoming a landlord can still carry significant financial benefits, but not without a slew of responsibilities and risks. If you’re thinking about turning your primary home into a rental, or have already done so, then this article is for you.
Most people know that the gain on the sale of their home is tax free so long as the gain is less than $250K for single individuals and less than $500K for married filers. Savvy taxpayers also know that you must have lived in this residence for 2 of the previous 5 years, and that the gain exclusion cannot have been used on a different residence within the past two years preceding the sale of your current home. What a lot of people don’t know, however, is a little pest known as “depreciation recapture.”
So, let’s dive into the issues here. A common situation we see with clients is that they own their current home and want to buy another. Instead of selling the current home to get into the new home, they choose to rent it out. Another common situation is when folks move to a new area, rent out their current residence and find a rental in their new neighborhood until they are ready to buy. Either way, the roots of depreciation recapture are beginning to take hold. But first, let’s talk a little bit about the benefits of depreciation. When a property is rented out, a taxpayer gets to deduct mortgage interest, property taxes, HOA dues, insurance, repairs, etc. against their rental income. All of the aforementioned are out of pocket expenses. Depreciation, however, is unique in that it is an expense for which cash is not paid. In fact, an individual can expense the portion of their home that represents the value of the building (one cannot depreciate land, because land does not lose its function over time, unless of course you live on some of the eroding cliffs we have here in San Diego) evenly over 27.5 years. Depreciation is very attractive to taxpayers as it can result in tax losses even when the property has positive cash flow.
So, what’s the deal with this depreciation recapture you ask? When you sell your home that you’ve been renting out for the last year or so, you may well qualify for the above mentioned gain exclusion. The problem is that you don’t get to exclude the portion that related to depreciation. So, if you deducted $30K in depreciation over the course of the rental, then you’re going to have to treat that $30K as income when you sell. What’s worse is that if you couldn’t figure out how to deduct depreciation on your bogus DIY tax software (I’m looking at you, TurboTax), you still have to pay tax on the depreciation recapture simply because you COULD HAVE taken it. That’s right folks, the IRS does not care whether you actually deducted the depreciation; the ability to deduct it renders you guilty. And where things get really bad is when you move back into that home after renting it out as you can lose out on a substantial chunk of the gain exclusion IN ADDITION to depreciation recapture. In the words of The Dude from the Big Lebowski, “this is a bummer, man.”
Trust me when I say there are about a bazillion different variants of the above situations and a bazillion different rules to accommodate those situations. As with all tax planning, you’d be wise to learn your options ahead of time (by talking to us!). The alternative is to have an IRS Ice Bucket Challenge thrown over your head where you don’t get to donate to an ALS organization, but rather are forced to donate to the First Lady’s flower garden.