Turning Primary Residence into Rental

General Real Estate Investing
1

Hello Everyone,

I have kind of a sticky situation. My wife and I have jointly owned our primary residence (let’s call this property A) since 1996 and have built quite a bit of equity in it. We recently decided to purchase a bigger place (let’s call this property B) and rent property A. I have three tax related objectives in this transaction:

  1. Protect my capital gains tax exemption (part 121 I think it’s called) that I have built to this point on property A should I decide to sell it at some point after it has been a rental (not our primary residence) for 3 years.

  2. Get my basis on property A as high as possible to maximize the tax benefit from depreciation. This would also help with objective 1 in that it would “reset” the capital gains basis.

  3. Refinance property A and use the proceeds to purchase our new primary residence (property B) and have the interest on this new mortgage be expensible, that is, be able to treat it as an expense to offset the rental income.

I’ve talked to several people and all tell me I’m essentially screwed on this. They say that my basis must be calculated from the original purchase price plus capital improvements and that if I use the proceeds of the refinance for purposes other than directly related to the rental (property A) then I won’t be able to expense the interest OR deduct the interest.

What really gets me is that if I were to SELL property A and use the proceeds to purchase property B, and then go out and purchase an investment property of the same value as property A (I could even repurchase property A for that matter) and take a mortgage on it, I would essentially achieve all three objectives. The problem with this is that first, I would rather not sell in this market and second, I like property A and plan to turn it into a part time vacation home at some point in the future and maybe even turn it back into our primary residence once the kids are grown and out of the house.

Can anyone think of a way to achieve these objectives without selling property A? Is there some sort of way to do an “arms length” transaction in order to achieve this? I’m not trying to beat the system here, I’m just trying to stop it from beating me.

Thanks in advance for any help!

2

Your plan could work, but you have a few holes that need to be plugged.

1) Protect my capital gains tax exemption (part 121 I think it's called) that I have built to this point on property A should I decide to sell it at some point after it has been a rental (not our primary residence) for 3 years.

Section 121 is a capital gains exclusion. The gain on the sale of your primary residence is not exempt from taxes, but instead, the first $250K (per taxpayer) is excluded from taxation. Sale profit that exceeds the exclusion amount will still be taxed.

To qualify for the capital gains exclusion, you must first own and occupy the property as your primary residence at least two years, then sell your property within three years after vacating it as your primary residence. Note that if you wait to sell until after three years of rental use, your property will be converted to an investment rental and it is no longer a primary residence. Your entire sale profit at that point in time will be subject to capital gains tax treatment.

2) Get my basis on property A as high as possible to maximize the tax benefit from depreciation. This would also help with objective 1 in that it would "reset" the capital gains basis.

Your friends are correct. Your basis begins with your original purchase price and is adjusted for capital improvements and depreciation allowed. I suspect you are thinking that your basis for depreciation is the appreciated FMV of the property on the day you convert it to a rental. This is wrong, your friends are right.

Additionally, there is no RESET for the capital gains basis. It does not matter whether the property was your primary residence or a rental when you sell it, your adjusted cost basis is still your original purchase price plus the cost of capital improvements and minus depreciation taken (or allowable if not taken).

Furthermore, when you sell the property, unrecaptured depreciation will still be taxed at 25%. The Section 121 capital gains exclusion does not apply to unrecaptured depreciation. Getting the depreciation basis “as high as possible” may just be setting you up for a higher tax bill when you go to sell.

Remember land can not be depreciated. The value of the land is subtracted from your cost basis to determine your depreciation basis.

3) Refinance property A and use the proceeds to purchase our new primary residence (property B) and have the interest on this new mortgage be expensible, that is, be able to treat it as an expense to offset the rental income.

Property A is now your primary residence. If you refinance and then use the amount that you “cash out” to purchase another primary residence, the mortgage interest is taken as a home mortgage interest deduction on Schedule A for your new primary residence. That amount is not expensed against rental income on Schedule E. Only the interest paid on the loan balance that you refinanced is expensed against rental income when you convert Property A to an investment rental.

It seems that you get the benefit of all of the mortgage interest regardless of whether it is included in your itemized deductions on Schedule A or expensed on Schedule E.

No need to complicate your recordkeeping here. Just get a new mortgage to purchase your new primary residence and have that mortgage secured by your new home. Don’t bother with a refinance on Property A, it won’t save you any money and probably won’t reduce your taxes at all.

The goal of this refinancing strategy eludes me. Unless there are extenuating circumstances you have not shared with us, I don’t see any tax advantage to your proposal, just an administrative headache in keeping up with the recordkeeping.

Consult your tax advisor for specific details.

3

Sell the house, take your homeowner’s exemption. Buy a new house for a rental.

The new house will have a much higher basis, and that is an advantage for you.

It doesn’t matter what the market is doing. Whatever you sell your house for, you can buy another one just like it for the same amount of money. The entire market in your neighborhood has changed. It hasn’t changed just for your house and not for anyone else.

4

You could sell your primary to a controlled entity and use the rent payments to finance the purchase. Just be extra careful to make it look like a legitimate sale and not a sham.

5

Originally I didn’t really understand this but it was explained to me that it makes no difference whether I use the interest to offset the rental income (sched E) or offset income form my day job (sched A). The effect will be the same in the end, UNLESS, I happen to be at the point where my itemized deductions are being phased out, which I happen to be. So, my understanding is that it would be better to take this on sched E.

6

You need to understand that the mortgage interest on your loan is tied to the asset you purchase with the loan proceeds. To be able to deduct the mortgage interest, the loan proceeds must be used for a qualified investment purpose and the interest is deducted in the manner allowed for that investment.

If you refinance your investment property to purchase a car and pay off credit cards, the mortgage interest is not deductibe nor expensable on Schedule E because the loan proceeds were not used to improve your rental property or to purchase another rental property. Additionally, the mortgage interest is not deductible on Schedule A because you did not use the loan proceeds for an investment purpose or to purchase another primary residence or a second home.

If you use the cash out from your refinance to purchase another investment property, then the mortgage interest on that amount is expensed against the income generated by that new property. If the property is not used for the production of income, then the interest on your loan is investment interest which is deducted on Schedule A with limitations but only if you itemize.

BTW, if your itemized deductions are beginning to be phased out, isn’t the net passive loss allowance also beginning to be phased out? The phase out of the passive loss allowance begins when your adjusted income reaches $100K and is phased out completely when income reaches $150K.

Consult your tax advisor for specific details.

7

Doesn’t this process make it preferable to generate Sch E losses rather than pushing the interest deduction to Sch A since E comes out before AGI is calculated?

8

jhorgan’s plan was to overcome the Schedule A limitations on his itemized deductions by claiming his Schedule A home mortgage interest deduction as Schedule E rental expense. Even if the IRS would allow it, I was simply pointing out that his passive loss allowance is also being phased out due to high income, so his plan may not reduce his taxes as he might have hoped.

9

What about taking House A and moving it into an LLC. This will allow him to carry more deductions since the home is now in a business. It will seperate the income and expenses from his personal return as well if done as a C-Corp.

10
Sell the house, take your homeowner's exemption. Buy a new house for a rental.

The new house will have a much higher basis, and that is an advantage for you.

It doesn’t matter what the market is doing. Whatever you sell your house for, you can buy another one just like it for the same amount of money. The entire market in your neighborhood has changed. It hasn’t changed just for your house and not for anyone else.

Yes, I had considered this. A couple of reasons, I’d like to keep the place to use during the summer and rent for 9 months/year when my financial situation allows it and then probably use it as a primary residence again when the kids move out (12-14 years from now). Also, I’d rather not pay the substantial commission on the roughly $700K sale price.

BTW, if your itemized deductions are beginning to be phased out, isn't the net passive loss allowance also beginning to be phased out? The phase out of the passive loss allowance begins when your adjusted income reaches $100K and is phased out completely when income reaches $150K.

They must be. I passed that mark a few years back. I don’t fully understand what passive losses are or the rules associated with them.

What about taking House A and moving it into an LLC. This will allow him to carry more deductions since the home is now in a business. It will seperate the income and expenses from his personal return as well if done as a C-Corp.

This sounds interesting. What would be the benefits and drawbacks to this approach?

Btw, thanks to everyone who has posted replies. I’m finding this very helpful.

11

Since a non-corporation LLC is a pass through entity, all the income and expenses of a rental property activity appear on your personal tax return anyway.

Separating the rental income activity from your personal tax return does happen with a C-corp because the C-corp files a tax return in its own right, but you have to deal with the administrative burden of maintaining a business entity and you may have a higher tax liability when your C-corp is deemed to be a personal holding company.

In my opinion, the short answer to your question is no advantages and a lot of drawbacks.