Tax considerations for converting a home to a rental

Have clients ready to retire and rent their family home? As a tax professional, you are critical in guiding them through the tax implications of converting a personal residence into a rental property. This can be a lucrative way to put unused assets to work, but it comes with important tax considerations, particularly regarding basis calculations and depreciation.

Determining the basis for a converted rental property

The basis of a rental property is essential in determining depreciation deductions and capital gains when sold. Generally, the basis of any asset includes the original purchase cost plus acquisition expenses, such as closing costs or commissions. These costs increase on an adjusted basis if improvements have been made, like a new roof, siding, or kitchen upgrades.

When a client converts a personal home into a long-term rental, the property is considered a business asset, and the basis calculation shifts. At the time of conversion, the basis is the lesser of the adjusted basis or the fair market value (FMV) on the conversion date. If the property was inherited or received as a gift, IRS rules differ in determining the basis. IRS Publication 551, Basis of Assets, provides guidelines on calculating basis when converting personal property to business use.

Claiming depreciation on a rental home

Once the property is a rental, it becomes eligible for depreciation deductions, a key tax benefit for landlords. IRS Publication 946, How to Depreciate Property, outlines depreciation methods and recovery periods. The modified accelerated cost recovery system (MACRS) is commonly used, but the straight-line method is also available. Residential rental property has a 27.5-year recovery life using the straight-line method.

Tax professionals should remind clients that depreciation starts when the home is placed into service as a rental, not when it was originally purchased. If improvements are made after the conversion, those costs may be added to the basis and depreciated separately. IRS Publication 527, Residential Rental Property, details the depreciation and expenses that can be deducted when renting a house for profit.

Key steps for tax professionals when converting a home to a rental

1. Determine basis: The converted basis is the lesser of the adjusted basis or FMV at the time of conversion. Refer to Publication 551 for more details.
2. Select depreciation method: Based on property classification, use MACRS or straight-line depreciation. Publication 527 provides guidance on depreciation and allowable deductions.
3. Track rental expenses: Keep detailed records of allowable deductions, including property taxes, mortgage interest, insurance and maintenance.
4. Consider partial business use: Depreciation and expense deductions must be allocated accordingly if the home is not used exclusively for rental purposes.
5. File Form 4562, Depreciation and Amortization: Report depreciation and amortization correctly on the client’s tax return.

Why clients need a tax professional

Converting a home to a rental property can provide great financial benefits, but the tax implications can be complex and costly if done incorrectly. NATP members stay informed on the latest tax regulations and are well-equipped to guide clients through basis calculations, depreciation strategies and IRS compliance.

If your clients are considering renting out their home, remind them that having an NATP tax professional ensures they make smart financial decisions while maximizing their tax benefits. Proper tax planning now can save them significant money and avoid issues in the future.