Should you convert your home to rental property?

Suppose you move to another house, but have difficulty selling your previous home. If it looks like it may take a while to sell that house, does it make financial sense to rent it? In addition to the economics of the situation, there are several tax factors you should consider first.

When you rent your home, you must report the rental income on your tax return. However, you can deduct the expenses of the home from that income, including utilities, operating expenses, repairs and maintenance, and depreciation. You can fully offset the income with these expenses. Due to the passive activity loss rules, however, losses can only be used to offset other passive income, with any excess losses carried forward to future years. That said, a favorable exception allows an individual with an adjusted gross income (AGI) of $100,000 or less to deduct up to $25,000 of passive losses against other income, as long as they are actively involved in the property's management. This deduction phases out with AGI between $100,000 and $150,000.

Pay attention to how long you rent your home, especially if you expect a profit from the sale. In general, you don't have to pay income taxes on up to $250,000 of gain if you are single or $500,000 of gain if you are married filing jointly. However, to qualify for the exemption, you must use the home as your principal residence in at least two of the five years preceding the sale. Even if you qualify for the exemption, the exclusion of the gain does not apply to the extent of any depreciation allowable with respect to the rental or business use of the home for periods after May 6, 1997. A maximum tax rate of 25 percent applies to the gain attributable to depreciation deductions.

If you sell the home at a loss, you can only deduct the loss if you prove the home was permanently converted to income-producing property. Your basis for calculating the loss is the lesser of your cost basis or the property's fair market value when it was converted to rental property. For instance, if you bought a home for $250,000, converted it to rental property when it was worth $225,000, claimed $10,000 of depreciation deduction, and sold it for $200,000, your loss would be $15,000 -- not $50,000.

Contact your CPA for details on how this will impact you.