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RENTING YOUR MAIN HOME OUT FOR HUGE TAX BENEFITS? Not so Fast...

Well, the funny thing about radio ads is that listeners hear what they want to hear. Specifically, the current ads running by "Rent Estate" on conservative radio shows are sure to tell you of the great TAX BENEFITS of keeping your home and renting it out instead of just selling it. And, if that home has any equity in it before you "convert" it from a private residence and into a rental property - the so called TAX BENEFITS turn into potential LOST TAX BENEFITS after just 6 months of rental time... and you have a PERMANENT loss of fantastic home sales rules (tax free selling) if you don't sell that home within 3 years after you moved out as long as you lived in it 2 of the last 5 years.

Instead, after losing a free sale up to $250,000 of gain if you are single or $500,000 if you are married and filing a joint return -- you will eventually convert that home with equity into a tax favor for the IRS and your state tax authority (if you live in a state that has an income tax). Now, that isn't so smart and sadly, the ads don't have proper disclaimer statements stated to warn you that selling any private residence home with equity is a permanent tax loss once that 3 year mark is passed. Any home owner with equity, especially a high amount of equity should go ahead and list and sell their home to take a permanent tax free sales gain. Or rent it out for a temporary time period at best, though doing so may reduce the value of your home since rental properties do not normally bring as much value at sale as homes never rented out. A stigma applies and a discount value is very possible if you rent your home out before selling it.

By just listing and selling your main home, the transaction now stays in your own private records if you are under the high tax free limits and is not even stated on the tax returns! And perhaps with all the money this country needs to pay it's future bills, including interest alone on national debt -- taking the sale now of a high equity home makes a lot of tax sense if you wake up in 2016 and find this Section 121 of the IRS code has suddenly been revoked. There are fantastic tax benefits in rental properties both residential and commercial. Residential rental homes are given 27 1/2 years of depreciation and commercial properties are given 39 years. But the people behind these ads and the broadcasters pushing those ads for money no doubt, are opening themselves up to legal challenges with the "tax benefits" promised if you just rent your home out instead of list and sell it. Again, only if you have equity in that home and especially if you have a high amount of equity. It might be a lot better to just sell your home and smile all the way to the bank with your tax free gain up to 1/2 million dollars! Then buy back any home you want, or homes with net equity after closing. Or just put the money into your retirement fund. Believe it or not, some people still think you have to replace your home with another home of the same or higher value. (That went out way back in 1997 folks)

The reason for selling keeps it simple but is best expressed by giving you an example:

You bought your main home in 1981 for $125,000. Today, that same home is appraising for $390,000 and after the expense of closing fees, you could net $375,000 of proceeds, minus any small mortgage payoff you may still have on the property. Using simple math, the IRS would say that you made a $250,000 gain. And regardless if you are single, married, or divorced - congratulate you by not taxing that gain and for being so smart YOU TOOK advantage of a tax law that at any time, could be wiped out in the future regarding home sales rules.

But, if you rent that same home out, and miss that 3 year deadline... you miss most likely the biggest ship of your life! If you sign a lease agreement to rent your home out, the IRS can easily say your intent was to rent it out as a rental property in some cases long before the 3 year time limit expires. Can you imagine renting for 2 years then 6 months more and then listing it 2 1/2 years from now -- and not finding a buyer to pay the listing price in time?  Double discounts would then apply. You are selling a rental and you will have to sell for less than full value to meet the deadline. And if you are close to the maximum tax free limit, has anyone ever told you ALL that depreciation a rental gives you year by year is recovered and deducted from the home basis? 

Not that it would be that big of deal since the BIGGEST mistake people make renting out their former home applies to all. Your basis for depreciation is based on your purchase price minus the value of the land beneath it. Yep, back in 1981 you paid $125,000 including the value of the land under your home. As a practicing professional accountant for decades, I can attest the IRS expects you to discount the original purchase price of a normal home (not a condo or townhouse) by a factor of 13-20% because of the value of the dirt under your home. Why? That land is not sticks and bricks and thus is not allowed a depreciation deduction.  Got a big lot or double lot?  Better take 20% or more discount to find the depreciation basis of your prior home now becoming a rental.

And here is the math: $125,000 purchase price - 15% for land ($18,750) = $106,250 basis divided by 27.5 years and allows a first year rental depreciation deduction on your main home converted to a rental of just $3,864 for the first year if you rent it the first day of January. Otherwise your first year depreciation deduction will be pro-rata for the year it was put in service per IRS rules. Compare that to the better option of selling your main home and buying another home, but a rental home this time and rent it out. It could even be next door or across the street by the way. The key is to replace, not keep a main home with a low basis for rental purposes. Now, you may not want to pay that $390,000 for just one rental. (Ask me why buying back two rentals would be smarter)

Here is the much smarter math that would apply if you sell and buy back:

$390,000 New rental purchase price - 15% for land value which is $58,500. That nets a depreciation basis for this newly purchased rental of $331,500. Your first year full depreciation (net basis divided by 27.5 years) would be $12,054!  Yes, it would be over 3 times more write off each and every year for 27.5 years! Do you really think renting your old home out versus selling it and buying back one or more rentals would put money in your pocket?  Of course not. It's just a lazy sales approach to trick you into thinking renting a main home out is the best way to go. But instead, it kills your Section 121 free gain rule on a main home if you rent beyond that 3 year deadline you are required to not only list but execute a closed transaction sale. Don't let some fast talking salesman convince you to lose 2/3 rds of your potential rental property tax write off for depreciation.

The whole idea of rental properties to achieve tax benefits is to get great monthly rent from steady and secure renters while producing a big negative figure to offset your day job or other retirement income. (More about that below) In fact, you permanently lose that big negative write off in my example here and may actually have to pay some income tax on your yearly rental income because your depreciation is greatly reduced from what it could have been. Where is the tax benefit in that?  Now a savvy salesman may say the more property you control the higher your net worth will go up. That might be true if values continue to rise on our real estate owned over the long run. But go for that goal with newly purchased rentals so your CPA or other tax professional preparing your tax returns doesn't give you this little "Pep Talk" after it's too late. SELL YOUR MAIN HOME if you have equity is what I am saying and especially if you have BIG equity. 

 Now, let me discuss those 3 tax traps:

1.  Not everyone can deduct rental losses on their tax returns. Make sure you understand "passive loss" rules before you buy or convert to a rental.

2.  Regardless of buying new rental property/ies, or renting your home out instead, don't get trapped to think that $20,000 kitchen redo can all come off in one year on your new Schedule E Rental Schedule. It takes 27.5 years folks to deduct it all!  However if you sell a rental or main home after being converted, at least the un-used portion of that kitchen upgrade will add to your basis for sales gain calculations and allow you to pay lower capital gains taxes (if held one year or longer).

3.  Unless you are still underwater on your home, don't lose Section 121 tax free gain rules on your main home. Understand the rule and understand tax law can change drastically, especially after an election year.

Noting: Most property sellers look at net proceeds from closing as their "gain".  Don't make that mistake. It has nothing to do with your net check you walk away from closing with. The IRS uses this formula to figure your gain: PURCHASE PRICE + IMPROVEMENTS - DEPRECIATION USED = Net Gain for tax purposes. Also noting if you are underwater with your home worth less than the payoff balance -- renting it out may be your only option anyway and I understand that. OK, that's it. Now, after a little "tax education", who still wants to rent their "high equity" home out now?  

Get a professional opinion before you make any major real estate move. Perhaps using a "Tax Smart" Realtor will help you avoid the traps and find the opportunities waiting for those who want to avoid the minefields yet get their assets into non paper assets.  Give me a call at 1-800-782-2806 no matter where you live. I can assist you either by personal representation here in Arizona or by referral to a qualified Tax Smart Realtor in your state. Or visit: www.mdandersonrealestate.com or www.TaxSmartRealEstateAgent.com.

M.D. Anderson

 

 

 

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MD Anderson Real Estate is a premier real estate service for both buyers and sellers of Arizona real estate, as well as those wanting professional referral services across the U,S. and in foreign countries.