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Turning Your Residence into Rental Property: Tax Planning for Your Real Estate Investments

Real estate is an attractive investment opportunity, but investors need to be prepared for potential taxes to truly maximize their profits. The way you are taxed on a property will first depend on how you acquired it. Common means of acquiring a property include simply purchasing it, inheriting it, or receiving it as a gift. 

One popular but potentially tricky way to earn money on a property is to convert your primary residence into a residential rental property. This strategy can come with a potential tax break, known as the Section 121 exclusion, which allows you to sell your primary residence and exclude up to $250,000 of earnings gained from the sale (or $500,000 for married couples filing jointly) from your income. 

To qualify, the property needs to have been your primary residence for at least two years out of the last five years since the date of sale. This means that you will need to be especially mindful of your move-out date and the date of sale. For example, if a property owner moves out of their residence in January 2020, then they would ideally sell the property by January 2023 to qualify for the 121 exclusion. In this case, the last five years would span January 2018 to January 2023 and the two-year minimum would be met from January 2018 to January 2020, assuming that the property was their primary residence throughout this period. Another approach is to move back into the property for a period of time to ensure the requirements will be met. 

Another strategy is to sell the property to an entity owned by the taxpayer, such as an S corporation, before converting it into a rental. This allows you to secure the 121 exclusion by gaining more control over the timeline for the sale. In this case, you will want to sell the property at fair market value—the same price it would go for if the sale was happening between two unrelated but well-informed parties. You will also want to wait until after you have claimed the 121 exclusion to convert the property into a rental. 

If your sales price is less than that $250,000 exclusion (or $500,000, depending on your filing status), you now have a tax-free sale! You also receive a step up in basis—the value of the property is adjusted to the current price (or higher price). When the property becomes a rental, you now have the potential to claim more tax deductions every year as the property depreciates, since your overall value is higher. So this strategy can come with more tax advantages than simply moving out of a property, turning it into a rental, and then dealing with the taxes down the road. 

Aspiring investors also need to look out for bad advice on how to secure tax breaks. For example, one popularized idea is that you can simply open an LLC and contribute your primary residence to the entity to receive tax deductions, including depreciation benefits. However, the popularity of LLCs has to do with asset protection, not tax benefits. Simply placing your personal residence in an LLC will not change the fact that the residence is still for personal use and therefore is not eligible for the special tax deductions investors are usually seeking. 

Another commonly-heard myth is that putting real estate into an entity makes you eligible to deduct any losses from that property. On the contrary, most real estate rentals are classified as passive under Section 469, and an overall loss on a passive activity does not automatically qualify for a tax deduction. You will still have to find and apply a specific tax strategy to secure a legal deduction. 

Overall, investors looking to generate income from a residence need to think about how the property is being used and when any changes in use occurred—this will help you determine your eligibility for any tax deductions. To learn more about tax strategies for real estate investing, contact a Certified Tax Planner today.

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