What are the Tax Implications of Renting your Primary Residence?

Overview: Tax Implications of Renting Your Primary Residence

Renting out your primary residence can have significant tax implications, affecting both your income tax obligations and potential capital gains taxes when you sell. You'll need to report rental income, but you can also deduct certain expenses. If you rent the property for more than three years, you may face depreciation recapture and partial capital gains tax upon sale. However, short-term rentals of 14 days or less are tax-free, and if you meet the 2-out-of-5-year residency rule, you may be able to exclude up to $500,000 in gains.

Here’s what you need to know:

1. Rental Income and Tax Reporting

• Any rent received must be reported as taxable income on Schedule E (Form 1040).
• You can deduct rental expenses, including:
  • Mortgage interest
  • Property taxes
  • Depreciation
  • Utilities (if paid by you)
  • Repairs and maintenance
  • Insurance
  • Property management fees
  • HOA fees
• If expenses exceed rental income, you may have a passive loss that can offset other passive income, subject to IRS limits.

2. The 14-Day Rule (Short-Term Rental Exemption)

• If you rent your home for 14 days or less per year, you do not have to report the income (IRS Section 280A).
• However, you cannot deduct rental expenses aside from property taxes and mortgage interest.

3. Depreciation Recapture

• If you rent the property for an extended period and claim depreciation, you must recapture that depreciation when you sell the property.
• This means you pay 25% tax on the total depreciation claimed, even if you later convert the home back to your primary residence.

4. Capital Gains Exclusion & Primary Residence Rules

• The Section 121 Exclusion allows homeowners to exclude up to:
  • $250,000 (single)
  • $500,000 (married filing jointly)from capital gains when selling their primary residence.
• To qualify, you must have lived in the home for at least 2 out of the last 5 years.
• If you rent the home for more than 3 years, you may lose this exclusion entirely.

5. "Non-Qualified Use" and Partial Gain Taxation

• If you convert the home to a rental, any time the home was used as a rental after 2009 is considered non-qualified use.
• This means a portion of your capital gains (based on the ratio of rental years to total ownership years) will be taxable, even if you qualify for the exclusion.

6. State and Local Taxes (SALT)

• Some states have additional taxes on rental income or may require estimated tax payments.
• Check local regulations regarding rental licensing, occupancy taxes, or short-term rental taxes.

7. Converting Back to a Primary Residence

• If you move back in after renting, the home may still be partially subject to depreciation recapture and capital gains tax on the rental period.

Tax Planning Strategies

• If possible, keep rental periods under 3 years to preserve the capital gains exclusion.
• Use a 1031 exchange if selling the property as a rental to defer capital gains tax.
• If you expect rental losses, ensure they can be offset against other passive income.
• Consider increasing home improvements (not repairs) before renting to raise the cost basis and reduce taxable gain.