5 Things to Know Before You Turn Your Home into a Rental Property

There are a number of reasons to turn a home into a rental property, or investment property, whether it’s your primary residence or a second/vacation home. If you had planned to sell and the housing market is weak, it might make sense to hold onto that property, rent it out to cover the mortgage payment, and wait to sell until the market recovers.

Of course, a rental property can also supplement your income. Depending on the location and how much you owe, a rental property can generate a higher return than the stock market.

However, turning a home into a rental property isn’t as simple as drawing up a lease and putting up an ad. There are a number of factors related to your mortgage and tax obligations that need to be considered before you become a landlord.

1) The Mortgage on the Property

Most mortgages require you to occupy the property as your primary residence for a certain period of time. Make sure that time has passed before turning the home into a rental property.

2) Insurance

Your homeowner’s insurance policy must be switched to rental property insurance before you turn your home into a rental property. Consider a personal liability policy to protect yourself from being sued by tenants. It’s also a good idea to require or at least recommend that tenants purchase renter’s insurance.

3) Personal vs. Rental vs. Personal/Rental

If your home is rented for fewer than 15 days per year, the home is considered a personal residence. That means rental income is excluded from gross income. Mortgage interest and real estate taxes can also be deducted as you normally would with your personal residence. Any other expenses, such as utilities and maintenance, are nondeductible.

The criteria for a rental property is a little more complicated. If your home is rented for at least 15 days per year and you do not use it for personal purposes for at least 14 days or 10 percent of the total days rented, whichever is greater, the home is considered a rental property.

For rental properties, all expenses must be broken down into personal and rental days. Real estate taxes allocated to personal days are deductible, but mortgage interest is not deductible because the home isn’t a qualified residence. If you end up with a rental loss because expenses exceed income, the loss may be deductible depending on at-risk and passive activity loss rules.

If your home is rented for at least 15 days per year and you use it for personal purposes for 14 days or 10 percent of total days rented, whichever is greater, you have a personal/rental property.

This scenario is very common for people who have a vacation home. This is also the most complex scenario from a tax perspective with very specific rules and conditions related to real estate taxes, mortgage interest, income, depreciation, expenses and reporting schedules.

Regardless of how your home is classified, the personal portion of the real estate taxes is subject to the new $10,000 limit on deducting state and local taxes. Make sure you speak with a CPA to understand the tax implications.

4) Rental Income

According to the IRS, rental income is any payment you receive for the use or occupation of a property. This includes not only rent payments, but also advance rent, payment for canceling a lease, expenses paid by a tenant, and property or services received instead of money for rent. Advance rent includes a security deposit if you don’t return it to the tenant. This income must be reported.

5) Recordkeeping

Monitor and maintain records of all rental activities to simplify the process of preparing financial statements, finding receipts, calculating deductible expenses, and filing tax returns. Also, you’ll need documentation of this information if you’re audited. Documentation is evidence. Without evidence to support the income and expenses you’ve reported, you could be subject to additional taxes and penalties.

Needless to say, turning a primary residence or second/vacation home into a rental property can be complicated. We always recommend focusing on your family first. How do you want to use the home? What are your goals? What will make you happiest? Once you answer those questions, your CPA can help you navigate the tax implications and put you in a position to realize the highest possible return on your investment.

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