How To Convert A Primary Residence To A Rental Property

Learn the pros, cons, and tax implications of converting your primary residence to a rental property, plus tips for a smooth transition and maximizing benefits.

Converting a primary residence into a rental property is a great way to generate additional income and build long-term wealth. However, it’s not quite as simple as buying a second property and keeping the first as a rental. There are insurance, finance, and legal issues, not to mention that operating a rental property is time-consuming and comes with a steep learning curve.

That being said, for some, holding onto an existing home as a rental can be a great financial option, particularly if the home was financed with a long-term mortgage at a favorable interest rate.

In this article, we look at whether it’s possible to rent out your primary residence, the pros and cons of doing so, and the potential tax implications of turning your home into a rental.


Contents


Key Benefits of Renting Out Your Primary Residence: Overview

Converting your home into an investment property offers several advantages, including:

  • Access Tax Deductions: While your rental income will be taxable, you will also be able to take advantage of the favorable tax benefits that come with being a landlord.
  • Rental Property Depreciation: A significant tax advantage of running a rental property is the depreciation deduction. This allows you to deduct the value of qualifying assets against your taxable income over what the IRS deems its ‘useful’ life. 
  • Generate Passive Income: Yes, there are significant overheads to running a rental property, but a good property in a good location should be cash flow positive, meaning you can enjoy an additional income stream. 
  • Build Equity in Real Estate: Build equity in an appreciating asset, all while your debts are covered by rental income. 

Renting your home instead of selling can also be a flexible option, allowing you the choice to move back should you need to once the lease term is up.

Why Convert a Primary Residence into a Rental Property?

Let’s break down the above benefits of converting a primary residence into a rental property in more detail. 

1. Tax Deductions

The tax implications of renting out your home vary depending on factors like location, rental duration, and more. But one thing remains true, while, rental income is taxable and must be reported to the IRS - normally using a Schedule E (Form 1040), you can reduce this taxable income through tax-deductible expenses

Common deductible expenses for rental properties include:

  • Advertising
  • Business-related travel
  • Cleaning and maintenance
  • Commissions for tenant placement
  • Insurance (including landlord liability coverage)
  • Legal and professional fees
  • Management fees
  • Mortgage interest
  • Repairs
  • Supplies
  • Property taxes
  • Utilities (when paid by the landlord)
  • Other ownership costs, like dues and education expenses

Related: A Complete Breakdown Of Schedule E Expense Categories

For example, if a rental property generates $24,000 in annual income and the total deductible expenses amount to $18,000, the taxable income would only be $6,000 which is then taxed at your standard income tax rate.

2. Depreciation Expense

Another advantage of renting out your former residence is the ability to depreciate qualifying assets including the property itself (excluding the cost of the land) over its ‘useful’ life. For residential property this is 27.5 years, and for commercial this is ‘39 years, as outlined in IRS Publication 946. 

Depreciation is an expense that accounts for the slow wear and tear of an asset over time and it can be a significant deduction.

To calculate depreciation, start with the cost basis - the original purchase price (minus land), closing costs, and capital improvements, or the home’s fair market value at the time of conversion, whichever is lower. 

For instance, if the property’s value is $300,000, with a $25,000 land value, the basis for depreciation would be $275,000. The annual depreciation expense would be calculated as follows:

$275,000 basis / 27.5 years = $10,000 annual depreciation expense

If the rental income after other tax deductions is $6,000 and depreciation is $8,000, the result is a $4,000 loss on paper, creating a passive activity loss (PAL) for that year. This loss amount would be carried forward to the next year (as passive activity losses are not deductible against other forms of income such as W-2 income).

3. Generate Passive Income

Rental income provides valuable cash flow that diversifies beyond traditional employment. Adding rental property to your portfolio enhances your financial resilience, especially if held long-term, where appreciation and cash flow work together to strengthen your investment returns.

4. Build Equity In Appreciating Assets

Leverage your rental property income to help pay off your mortgage loans and pay down your debt. This allows you to build equity in multiple appreciating assets, all while taking advantage of the various tax benefits of being a real estate investor

Tax Implications of Selling a Primary Residence Converted to Rental

Converting a primary residence into a rental property has benefits, however, there are also several tax implications to turning your home into a rental.

As mentioned above, rental income is taxable and needs to be reported at the end of the year on a Schedule E Form 1040 which deals with supplemental income and losses. Additionally, you will need to familiarize yourself with several other new tax forms such as 1099 forms.

On top of this, should you later sell the property after renting it out you may face capital gains tax as well as depreciation recapture. 

As a landlord, you need to understand these various tax implications of renting your primary residence and form tax strategies in line with your long-term financial goals.

1. Depreciation Recapture Tax

When a property is converted to a rental, owners can claim depreciation to reduce taxable rental income. However, upon selling, any depreciation claimed must be “recaptured” and taxed as ordinary income, up to a maximum rate of 25%.

For example, if a property was converted five years ago with a depreciable basis of $220,000 (excluding the land value) and accumulated $40,000 in depreciation over those five years, the depreciation recapture tax at 25% would total $10,000.

2. Capital Gains Tax

Any profits on the sale of the property are subject to capital gains tax, calculated at long-term rates of 0%, 15%, or 20% depending on the taxpayer’s income bracket.

If the converted property originally valued at $250,000 sells for $325,000, the gross profit is $75,000. After deducting eligible closing costs, such as commissions, legal fees, and title fees (totaling $16,250 in this example), the taxable gain would be $58,750. If taxed at a 20% rate, the capital gains tax would be $11,750.

3. Passive Activity Loss (PAL)

The IRS generally classifies rental real estate activities as passive. Importantly, passive losses can only be claimed against passive income. However, passive losses can be carried forward to future tax years if not immediately usable.

For instance, if future rental income exceeds expenses and depreciation, carried-forward PALs can offset future profits, creating a valuable tax advantage over time.

Related: What Does It Mean To Materially Participate In Real Estate?

4. Self-Employment Tax

Rental income is considered passive income, exempt from self-employment taxes like Social Security and Medicare. Typically, self-employed individuals must pay a 15.3% FICA tax, but rental income isn’t subject to this tax. Thus, $50,000 in rental income, for example, would avoid a FICA tax liability of $7,650, boosting your take-home income.

5. The “2 out of 5 Year Rule”

If you lived in the home as your primary residence for at least two out of the five years before selling, you may qualify for the primary residence exclusion for those tax years. This exempts up to $250,000 ($500,000 for married couples filing jointly) from capital gains tax. 

Importantly, this is only for the period that you lived in the property. For example, you bought the property for $400,000, lived in it for two years and rented it out for three years afterward, then sold the property for $500,000. This would be a capital gain of $100,000. Because you lived in the property for two of the five years, 40% of that capital gains would be exempt under the primary residence exclusion. 

Using a Section 1031 Exchange to Defer Taxes

Before we move on from the tax implications of renting out your primary residence, we wanted to quickly cover 1031 exchanges. This is a tax strategy that allows rental property owners to defer both capital gains and depreciation recapture taxes. Investors can sell a rental property and purchase another “like-kind” property, provided they follow specific guidelines:

  • Replacement Property Value: The new property must be of equal or greater value.
  • Identification Period: A new property must be identified within 45 days.
  • Purchase Timeline: The replacement property must be purchased within 180 days.

Multiple 1031 exchanges can be conducted over time, deferring taxes indefinitely. Additionally, if the property is passed on to heirs, the cost basis is “stepped up,” eliminating deferred taxes on capital gains and depreciation recapture and allowing generational wealth to be built.

Take Advantages of Real Estate Investing Tax Benefits With Purpose-Built Software

Landlord Studio is a comprehensive property management and accounting software, built to help you maximize your rental property’s performance. Our award-winning accounting tools simplify income and expense tracking, while customizable reports make it easy to analyze your property’s profitability and streamline tax filing.

With features like online rent collection, automated income tracking, a built-in receipt scanner, mileage tracking, and direct bank feeds, Landlord Studio keeps your finances organized and ensures you never miss a tax-deductible expense

But Landlord Studio is more than just accounting. From tenant finding and screening to property maintenance tracking, rent collection, document storage, and lease management, it’s everything you need to manage your properties seamlessly - all in one place.

Stay compliant with tax requirements, save time, maximize deductions, and boost your ROI with software built for landlords. Create your free account today.

Challenges When Converting a Primary Residence to a Rental

While converting your home into a rental property has its perks, there are several challenges that new landlords should anticipate. 

Success Takes Time and Effort

Converting a primary residence to a rental property requires time and significant effort. Finding tenants, arranging property showings, screening tenants, drafting leases, coordinating move-ins, and handling routine maintenance and repairs are just a few of the regular tasks that need to be handled when running a rental - there are no shortcuts.

Self-Management vs. Hiring a Property Manager

If you live near your property managing it yourself can help you save money - especially if you have quality property management and accounting software like Landlord Studio to help you.

However, if you live further away, out of state or country, or simply don’t have time, you might consider hiring a property management company to handle these duties. This can add to your costs but free up your time and reduce the challenges of direct management.

Related: How Much Do Property Managers Charge? Property Management Fees

Staying Informed About Laws and Regulations

While there are some overarching federal laws, like the Fair Housing Act (FHA) and Fair Credit Reporting Act (FCRA), many rental property laws vary from state to state and even from city to city. 

Be sure to review local regulations around things like maximum rent increases, security deposits, and eviction laws, and check if your homeowner’s association (HOA) has policies restricting rentals or occupancy by non-owners. 

Related: Landlord-Tenant Legal Guides By State

Managing the Rental Process

As mentioned above, being a landlord means running a business. A few key tasks you should familiarize yourself with include:

  • Finding and Screening Tenants: To secure reliable tenants who pay rent on time and respect the property you’ll need a process for thoroughly vetting applicants. You can use Landlord Studio to create rental listings, share them across top channels like Zillow, and collect and manage rental applications and tenant screening reports.
  • Property Inspections and Maintenance Management: Conduct a detailed inspection before tenants move in, create a list of quality contractors you can call in emergencies, and set up a system for prompt maintenance requests - you can use Landlord Studio to collect, track, and prioritize maintenance requests.
  • Rental Agreements & Contracts: Create a comprehensive rental agreement outlining key clauses, such as rent obligations, property use restrictions, and lifestyle policies. Consult a real estate attorney for legal soundness.
  • Collecting Rent: Establish how you're going to manage and track rent payments from your tenants. The easiest way to do this is with free online rent collection software like Landlord Studio.
  • Security Deposits & Rental Payments: Clearly define financial policies, including the security deposit amount, rental due dates, payment methods, late fees, and eviction rights to protect your income and ensure compliance.

Budgeting and Financial Tracking

Budgeting for rental property expenses is essential to understanding your cash flow potential. Key costs include mortgage, insurance, maintenance, property taxes, legal and administrative fees, and utilities. By creating a preliminary budget that accounts for these expenses along with projected rental income, you can better gauge your expected cash flow in your first year as a landlord.

Once you have your budget and forecast it’s essential that you stay on top of your rental property bookkeeping, tracking every deductible expense, so you can ensure you stay on budget, and maximize your potential revenue.

Complex Tax Implications

Rentals are a business and come with various tax strategies, deductions, and liabilities - as outlined above. Understanding these tax implications in detail will allow you to implement an effective tax plan and achieve a profitable return. Otherwise, you could find your plan to generate passive income could get you in trouble with the IRS, or end up with negative cash flow.

It’s always recommended that you talk with a tax professional if you have any concerns.

Related: How Does The IRS Know If I Have Rental Income? 

How to Convert Your Primary Residence into a Rental Property

Turning a primary residence into a rental can be a wise choice, but it's essential to follow the right steps. Here’s a seven-step guide to help you transition smoothly:

  1. Evaluate the Pros and Cons: Consider the financial benefits and responsibilities of renting out your home. Compare potential rental income with the costs of maintaining the property as a rental versus selling it outright.
  2. Confirm HOA Rules: Check with your homeowners association (HOA) to ensure renting is allowed. Some HOAs have restrictions on rentals or require specific approvals.
  3. Inform Your Mortgage Provider: If you have a mortgage on the residence you are looking to convert into a rental you may want to discuss this with your lender. Many consider this kind of investment loan more risky and it could be a breach of your original loan terms.
  4. Update Insurance Coverage: Notify your insurance provider that the property will become a rental. Standard homeowner’s insurance won’t cover rental situations, so you’ll need a landlord policy to protect your investment.
  5. Obtain Necessary Permits and Licenses: Some cities or states require landlords to register and obtain permits or licenses and may require you to collect rental or sales tax. Make sure you’re compliant with local regulations.
  6. Prepare the Home for Renters: Get the property ready by completing any necessary repairs, setting a competitive rental rate, and advertising the rental. Be sure to screen potential tenants thoroughly, sign a state-compliant lease, and set up a reliable rent collection process.
  7. Set Up a System for Income and Expense Tracking: Establish a clear system for tracking rental income and expenses, taking advantage of potential tax benefits. Good record-keeping can simplify tax reporting and help you maximize deductions as a rental property owner.

Related: How to Use HELOC for Investment Properties

Final Words: Converting Primary Residence To Rental Property

Converting your primary residence into a rental property can be a lucrative investment strategy that offers both financial rewards and long-term wealth-building potential. However, it is essential to approach this transition with a clear understanding of the tax benefits and legal responsibilities of being a landlord.

Key advantages include the potential for tax deductions, the ability to depreciate your property, and the opportunity to generate passive income while building equity in a valuable asset. Yet, these benefits come alongside challenges such as managing tenant relationships, maintaining the property, and navigating local regulations.

Utilizing tools like Landlord Studio can help you start off on the right foot. Providing you with a suite of powerful tools that will help you streamline operations and stay organized, so you can run a profitable rental property.

FAQs: Converting Your Primary Residence into a Rental Property

Here are some frequently asked questions from aspiring landlords like you.

What is the cost basis for a primary residence converted to rental property?

Generally, the cost basis is determined by the purchase price of the property, plus any capital improvements made, and any casualty losses claimed for tax purposes. However, cost basis can be complex, so it’s best to consult a licensed CPA who can evaluate your specific situation.

How long do I need to live in my primary residence before converting it to a rental property?

While a common recommendation is to live in your primary residence for at least 12 months before converting it to a rental, there are no strict tax rules on this timeline. Consulting a qualified tax professional can help you evaluate your specific risks and opportunities.

Is it common to rent out my primary residence immediately after purchase?

Renting out your home right after purchasing it is generally not typical. However, some lenders may allow exceptions based on specific circumstances.

How do I determine the market value when converting my primary residence to a rental?

The market value of the property is usually determined by the lesser of the fair market value or the adjusted cost basis at the time of conversion from primary residence to rental.

What are the tax implications of renting out your primary residence?

Renting out your primary residence has several tax implications, including:

  • The requirement to report rental income as taxable income on your tax return, typically using Schedule E. 
  • You can deduct various expenses related to the rental property, such as mortgage interest, property taxes, repairs, and depreciation, which reduces your taxable income. 
  • When selling the property, capital gains tax may apply to any profits, though you may qualify for a capital gains exclusion if you've lived in the home for at least two of the last five years. 
  • Depreciation recapture tax will also apply upon sale, taxing previously claimed depreciation as ordinary income. 
  • Additionally, rental income is usually not subject to self-employment taxes, 
  • and if you reinvest in another property, a Section 1031 exchange may allow you to defer capital gains taxes.

It's crucial to consult a tax professional to navigate these complexities and optimize your tax benefits while remaining compliant with tax laws.

What are the tax implications of converting rental property back to a primary residence?

If you decide to revert your rental property back to a primary residence, you will lose eligibility for certain tax deductions, such as those related to repairs. Additionally, when you eventually sell the property, it’s important to understand how this affects your cost basis and capital gains tax. Consulting a licensed CPA can provide clarity on the potential tax consequences.