Conversion of Primary Residence to Rental Property

Have you ever wondered about turning your home into a rental property? When life changes, like a new job or a growing family forces a move, many homeowners consider keeping their first home to lease out instead of selling. The prospect of extra monthly income without selling a property you know and love is an appealing one. 

But before you hang out a “For Rent” sign and tally up profits in your head, pause to take in the full picture. Navigating the transition from resident to first-time landlord requires some real know-how. Success involves more than snapping some photos for your rental listing and calling it a day.

This guide is your crash course on converting your primary home into an investment property. We’ll explore the practical steps involved, discuss some of the not-so-obvious costs, and walk through the process in real-world terms. 

Why turn your home into a rental property?

Converting your home into a rental property can provide several key advantages, like tax deductions and income diversification, that make it an appealing option worth considering for many homeowners. Key benefits of turning your personal residence into a rental include:

Tax deductions

As a landlord, you have the advantage of reducing your taxable income through deductions for various rental property expenses. These deductions can include mortgage interest, property taxes, insurance premiums, maintenance costs, and repair expenses. By claiming these expenses on your tax return, you can significantly lower the amount of income subject to taxation.

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Let’s look at an example.  When you rent out your personal residence for $1,500 a month and incur $1,000 in monthly expenses associated with the rental, your net rental income amounts to $500. This calculation is made by deducting the allowable expenses—as mentioned above—from your total rental income. Therefore, this net income of $500 is considered for tax purposes and contributes to your overall taxable income, not the initial $1,500.

Depreciation benefit

You can claim depreciation expenses on rental properties as another tax advantage. This allows rental property owners to deduct the cost of purchasing and upgrading the property over its lifespan to account for wear and tear from renting.

The IRS has set depreciation schedules for rental real estate. For most properties bought after 1986, the standard depreciation period is 27.5 years. Calculate this by dividing the property value (excluding land) by 27.5 years.

So, if you bought a rental property for $200,000, excluding land cost, the yearly depreciation deduction would be $200,000 / 27.5 years = ~$7,273 per year.

This can provide a major tax benefit when cash flow is tight in the early years of rental ownership. Just note you’ll need to pay taxes on claimed depreciation when you sell.

Offsetting losses

If your rental property generates a loss for tax purposes, you can offset that loss against other passive income, like income from other rentals or investments. This is called a passive activity loss (PAL).

For example, if you have two rental properties and one makes $5,000 in profit while the other has a $3,000 loss, you can use the loss from one property to offset the profit from the other, reducing your total taxable rental income.

However, there are limits to using PALs. If your adjusted gross income is over $150,000 for married couples filing together, you may not deduct all rental losses in the current year. Instead, you can carry them forward to future years with lower income or more passive income.

Avoid self-employment tax

Converting your primary residence into a rental property allows you to generate income from the property without paying extra self-employment taxes. This tax applies to income earned from operating your business or freelance work.

The self-employment tax rate is 15.3% on net earnings to fund Medicare and Social Security. By renting out your home instead of earning extra money through business/freelance income, you can avoid paying this additional tax and keep more of your rental proceeds.

Diversifying income and cash flow

Owning rental property allows you to diversify and stabilize your income streams. Unlike the stock market, rental income tends to be steady and predictable when you attract good long-term tenants and maintain the property.

Owning real estate also provides an inflation hedge. As living costs rise, you can increase rent to keep pace with inflation and ensure rental proceeds hold their value. This helps strengthen your total income as other sources lose purchasing power.

Challenges to consider before converting

Of course, becoming a landlord also comes with responsibilities and risks. Before converting your primary residence into a rental property, it's important to consider the drawbacks as well.

It takes time to succeed

Turning your property into a profitable rental business is a gradual process that requires consistent effort over years, not months. This is not a quick way to make money, and success is not guaranteed.

You'll need to actively promote your rental, thoroughly vet tenants, promptly handle maintenance issues, aggressively save for vacancies and repairs, and tightly manage finances. Time and hard work are necessary to establish reliable income streams through good tenants who pay on time and properly maintain the property.

Learn to prepare an annual budget

Operating a profitable rental requires carefully budgeting for annual expenses. Tracking projected costs versus potential rental income helps set expectations on cash flow, guides rental rate decisions, and guides investments into other rental properties.

Key expenses to include in your rental property budget include:

• Your mortgage payments
• Property taxes
• Insurance premiums
• Maintenance and repair expenses
• Utility bills
• Property management fees
• Costs for vacancies
• Legal and accounting fees

Tax implications

If you turn your primary residence into a rental property and then decide to sell, there are tax impacts to be aware of, including:

Depreciation recapture tax

As mentioned, owning a rental property lets you deduct depreciation expenses yearly. When you sell the property, you'll have to "recapture" the depreciation you've deducted and pay taxes on it.

Depreciation recapture means the IRS taxes you on the depreciation deductions you've taken over the years. Typically, the tax rate for depreciation recapture is 25%, which can vary depending on how much depreciation you've claimed.

Suppose you purchase a rental property for $200,000 and claim $50,000 in depreciation expenses over time. Upon selling the property, you'd owe $12,500 in depreciation recapture tax, which is 25% of the $50,000 depreciation.

Capital gains tax

You'll also have to pay capital gains tax when you sell your rental property and make a profit. This tax rate depends on how long you've owned the property and your income tax bracket.

You'll pay short-term capital gains tax if you've owned the property for less than a year. Your regular income tax rate determines this tax, which can reach up to 37% for the highest earners.

If you've owned the property for more than a year, you'll pay long-term capital gains tax, usually at rates of 15% or 20%, depending on your income.

For example, say you purchased a rental for $200,000 and sold it 5 years later for $300,000. Your capital gain is $100,000 ($300,000 sale price minus $200,000 purchase price). At a 15% capital gains rate, you would owe $15,000 in capital gains tax on the $100,000 profit.

Section 1031 Exchange

You can potentially defer capital gains taxes when selling a rental property by using a 1031 exchange. This allows you to swap the rental property for another one without incurring immediate tax liability on the sale.

The rules to qualify for a 1031 exchange tax deferral include:

• Identify the new rental property within 45 days of the sale.
• Complete the exchange within 180 days of the sale.
• The new property must be equal to or greater in value than the sale property.
• A qualified intermediary facilitates the exchange.

If you meet all the guidelines, your capital gains taxes can be postponed until you later sell the replacement property. At that point, you realize any accumulated depreciation recapture and gains on both properties as income.

Step-by-step guide to converting your primary residence

Converting your primary home to a rental property can be a smart financial move. Here are the key steps to follow:

1. Check if you can rent out your property

If you have an existing mortgage on the property, contact your lender first to confirm your loan terms allow you to rent out your personal residence. Some mortgages prohibit operating the property as a rental.

Next, research rental rates in your local market by reviewing listings for comparable properties. Look at features, square footage, bedrooms/bathrooms, location, etc. This helps you evaluate pricing and demand factors to determine if your property can generate sufficient rental income versus expenses.

Aim to set your asking rent around the average rates for similar rentals. Consider boosting above average if your property has superior upgrades or amenities renters value.

2. Get necessary permits and licenses

Renting regulations for residential properties vary significantly by county and city. Research what permits, licenses, inspections, taxes, tenant checks, zoning rules, and other rental regulations apply in your local area.

Common items needed include:

• Local business license to operate a rental property
• Passed property inspection confirming safety codes
• Registration for rental income taxes

Also, some areas restrict short-term or vacation rentals. Take time to investigate all applicable rules to avoid fines or barriers when leasing your property. Consulting a local real estate attorney can also help you navigate the rules.

3. Check your insurance

When converting your primary residence into a rental property, one of the most important steps is to review and update your insurance policy. Homeowner's insurance for a primary residence differs significantly from landlord insurance, which is specifically designed to cover rental properties.

Landlord insurance typically offers protection against property damage, loss of rental income, and liability in case tenants or their guests get injured on the premises. It's essential to contact your insurance provider to discuss the change in property use so they can adjust your coverage accordingly. This ensures that you are adequately protected against potential risks associated with renting out your property.

Additionally, it's advisable to encourage your tenants to get renters' insurance to cover their personal belongings, as landlord insurance does not extend to tenant-owned items.

4. Make required repairs and upgrades

Prior to listing your rental, be sure it is in good and marketable condition. The investments into repairs and presentation often provide strong ROI over time through higher rental rates and tenant retention.

• Repair identified property issues from inspection reports, including systems, fixtures, appliances, etc.
• Upgrade the interior/exterior with painting, flooring, and lighting to appeal to prospective tenants.
• To facilitate positive first impressions, perform deep cleaning, declutter, and organize the layout.
• Confirm functionality of locks, detectors, warranties, and access to amenities.

5. Determine rental price and create a lease agreement

Once your property is ready, decide how much rent to charge and create a lease agreement. Use your research to set a fair market value rent price.

Outline key terms like the amount and timing of rent, maintenance responsibilities, and renter's insurance requirements. Set clear contractual expectations upfront.

6. Market your property and screen potential tenants

With your rental property ready, it's time to find quality tenants. Create listings on major rental platforms. Craft your listing with details on the property's best features and amenities to attract interested renters.

As you receive rental inquiries, use a rental application to screen candidates thoroughly. Verify employment and income, run background checks and credit reports, and call previous landlord references to confirm rental history.

7. Set up a system for rent collection and managing your property

Finally, use a property management software platform like Azibo to handle rent collection, maintenance requests, and tenant communication. This consolidated approach streamlines important but time-consuming rental tasks through purpose-built tools like:

• Online rent payment and tracking
• Maintenance portals and reminders
• Tenant messaging and response logs
• Income and expense dashboards

Alternatives to self-management

If handling all the responsibilities of managing your rental property sounds overwhelming, consider hiring a property management company. These companies take care of everything from finding tenants to handling repairs and collecting rent.

While they charge a fee, usually around 8-10% of your monthly rental income, their convenience and stress-free ownership can be worth it.

Converting primary residence to rental property

Turning your home into a rental property is no small decision. Do your homework upfront and know what you're getting into.

If you educate yourself on the guidelines where you live, create a solid budget, and prepare for the job of being a landlord, it can absolutely pan out. But don't underestimate the work of managing tenants, repairs, marketing, and everything in between. Going in, expect that it will take time to see success.

At the end of the day, take an honest look at your goals. If you're willing to learn the ropes and manage well, the numbers can work in your favor over time. Approach this as an opportunity, not a get-rich-quick scheme. Be ready to ask questions and adapt. With realistic planning and patience, that “for rent” sign out front could lead to meaningful rewards down the road.

Conversion of primary residence to rental property: FAQs

What insurance do I need when converting to a rental property?

When renting out your property, switch from standard homeowner's insurance to specific landlord liability insurance designed for the unique risks created by tenants.

Can I convert back to using the rental property as my primary residence in the future?

Yes, you can move back into the investment property at any time in the future if your living situation needs to change. Just be mindful of tax implications and mortgage terms.

What is the 2 out of 5 year rule for rental property?

This rule means that you own and live in the property for two out of the last five years to qualify for capital gains tax exclusion.