In an earlier post, we talked about the desirability of renting out a spare bedroom in your primary home. As we argued, renting out a spare bedroom can be a great means to generate additional income. For whom the option be available, converting your entire home into a rental property can be a means to generate even more income. However, not everyone can make this work. For one thing, converting your home into rental property means that must have a second property which would be suitable as primary home. Further, converting your home into a rental requires a good bit of effort and energy. When you become a landlord, you will bring about a whole bunch of responsibilities which can be time-consuming and draining. These are definitely things you need to consider when you decide to convert to a rental.
When you go to make the decision to convert your home into a rental property, there are two things in particular you need to be aware of. These things can have significant financial implications at some point down the road. Let’s take a look at these two things in detail.
You May Lose Access to the Principal Residence Exclusion
One of the most potentially valuable tax perks in our tax code is the “principal residence exclusion” under Section 121. This exclusion allows homeowners to eliminate a certain amount (up to $250,000 for individuals and $500,000 for married couples) of gain when they sell their principal residence. These are big numbers. If a married couples eliminated the maximum amount of gain, this could be a savings of upwards of $100,000 (depending on the specifics). In order to use Section 121, however, you’ll need to follow certain rules. One rule is that you must live in the home for at 2 years, and those 2 years must occur during the most recent 5 year period. These 2 years needn’t be consecutive. This means that if you live in your residence for 1 year, live elsewhere for 2 years, and then move back to the residence and live there for another year, the exclusion would be available.
If you convert to a rental, you need to be aware that could lose access to this key exclusion. If you rent out your home and live elsewhere for longer than 3 years, you’re going to lose the exclusion for that home. The only way to reclaim the exclusion would be to move back into the home and live there long enough to reestablish the ownership requirement. This is definitely something you need to consider given the magnitude of the exclusion. In some cases, the savings generated by the exclusion would be sufficient to cover many years of rental income.
You May Be Able to Use Sections 121 & 1031 at the Same Time
If you convert your home into a rental property, a unique opportunity may be available to you if you ultimately decide to sell the property in a 1031 exchange. This unique opportunity comes about through the exception to “nonqualified use” under Section 121(b)(5)(C)(ii)(I). If you convert your property to a rental and then sell it in a 1031 exchange, you may be able to take advantage of the full exclusion and also defer your entire liability. This is only possible if you’re still eligible for the exclusion after you convert, which means that you must still satisfy the ownership requirement (2 years within the most recent 5 year period). So, if you convert your home into a rental, rent it out for 2 ½ years, and then sell it as part of a 1031 exchange, you’d be able to exclude the maximum amount of gain and also defer your remaining capital gain taxes using Section 1031! As you’ve noticed, the rules for using these sections can be a bit tricky, so it’s always advised that you consult with a qualified tax professional beforehand. But, the key point here is that you’ll be in a unique position to take certain advantages from the tax code when you convert your home to a rental.
Image credit: Selamat Made