Key Tax Facts for Landlords
If you are considering renting your home, even for just a short time, after you move out of it and before you sell it, tread very carefully! After you've converted your house into rental property, you can't avoid taxation on the profits from that property simply by purchasing another primary residence.
- If you do decide to turn a property into a rental and then later sell it, you can roll over your capital gain into another "like kind" investment real estate property. Currently, the IRS broadly defines what a "like kind" property is. They allow you, for example, to exchange undeveloped land for a multi-unit rental building. Just remember that the IRS does draw a sharp line between a primary residence and a rental property, and they won't let you roll profits over that line.
- The rules for rolling over a gain from one rental property to another (called a 1031 or Starker exchange) are strict. To begin with, you are allowed little time to complete the rollover -- only 6 months -- and you must also identify a replacement property within 45 days of the sale of the first property. You are not allowed to handle the proceeds: They must pass through an escrow account. Because of the complexity of the transaction, it makes sense to find an attorney and/or tax advisor who can guide you through the process and ensure that you do it right.
Know how to defer your investment property profits
Taxable profits on the sale of an investment property are often much greater than on a comparable residential property. That difference is because the IRS lets you depreciate investment property while you own it and deduct the depreciation amount from your income taxes every year. However, when you sell the property, you must factor the depreciation you took on the property into the property's adjusted cost basis.
- Suppose that you buy an investment property for $150,000, and many years later you sell it for $300,000. During your years of owning the property, you claim a total of $50,000 in depreciation on your tax returns. The amount of depreciation reduces your cost basis from the original $150,000 purchase price to $100,000, thus making your "taxable profit" that much larger. You owe capital gains tax on $200,000 -- the difference between the sale price of $300,000 and the adjusted cost basis of $100,000.
- Fortunately, you can defer taxes on these gains by rolling over your profits into another investment property. If you simultaneously sell an investment property and buy another, that one exchange is called a 1031 exchange. If the exchange is not simultaneous -- that is, if you delay your purchase of the second property -- you must meet some very specific requirements (called the Starker rules, after a famous tax case).
- If you're going to do a Starker or a 1031 exchange, be sure to enlist the help of an attorney or tax advisor who's an expert at these transactions to ensure that you do it right. You need an experienced professional to help you jump the many legal hoops (such as filling out special tax forms like Form 8824, which tells the IRS that you bought a "like kind" investment property).