If you’re considering renting your home, even for just a short time, after you move out of it and before you sell it, tread carefully! After you’ve converted your house into rental property, you can’t avoid taxation on the profits from that property simply by purchasing another primary residence.
We don’t mean to frighten you out of turning your house into a rental property. You don’t lose all your tax breaks; you get different ones. If you decide to turn a property into a rental, and then later sell it, you can roll over your capital gains into another “like kind” investment real estate property.Currently, the IRS broadly defines what a “like kind” property is. It allows you, for example, to exchange undeveloped land for a multi-unit rental building. Just remember that the IRS draws a sharp line between a primary residence and a rental property, and it won’t let you roll profits over that line.
The rules for rolling over a gain from one rental property to another (called a 1031 exchange) are strict. To begin with, you’re allowed little time to complete the rollover — only six months — and you must also identify a replacement property within 45 days of the sale of the first property. You aren’t allowed to handle the proceeds: They must pass through an escrow account. Because of the complexity of the transaction, please do yourself a favor and find an attorney and/or tax advisor who can guide you through the process and ensure that you do it right.
Before you consider converting your home into a rental property, in addition to understanding the tax issues that we just discussed, also weigh the following:
- How do you feel about being a landlord? Managing a rental property takes time, patience, and knowledge of local rent-control laws. Some tenants are a pain, and premises occasionally need repairs. You can hire a property manager, but this service costs money, and finding a good one can be a challenge.
- What about wear and tear? If you’ve gone to great lengths to make your house immaculate, realize that renters aren’t going to treat your home with the same loving care that you gave it. Although you can protect your interests somewhat by securing from your tenants a large security deposit (at least one month’s rent), you can’t expect them to pay for the inevitable and gradual wear and tear.
For documentation purposes, you may also videotape the interior of the rental, including the condition of floors, walls, and so on. Beware, though; you may find that, at the end of the lease, your tenants disagree with you over what you think is unreasonable wear and tear.
- What’s the cash flow? Tally up all the monthly property expenses that you anticipate and compare that amount with the expected rental income. If you’ve recently bought your property or have little equity in it, you may be unable to turn a profit. The worst-case scenario is that the additional monthly cash drain cramps your budget and causes you to accumulate consumer debt or underfund your tax-deductible retirement accounts.