Plan ahead before putting your house up for rent

Nation's Business, Jan, 1992 by Albert B. Ellentuck

Most homeowners who want to sell their homes these days aren't having much luck. Pending a sale, some may have to rent to cover mortgage payments and maintenance costs. And even then, the home might have to be sold at a loss. But valuable tax breaks are available to sellers who plan carefully.

Although rental income is taxable, the property owner can deduct mortgage interest and real-estate taxes. Such expenses as depreciation, repairs, insurance, maintenance, and utilities can also be deducted, but if they--plus interest and taxes--exceed rental income, the expenses generally cannot be deducted against other investment or earned income.

If, however, the home is "converted" to an investment property, rental losses can be used to offset other income, subject to certain limits.

But a homeowner cannot have it both ways. If property has appreciated and the homeowner expects to sell it later at a profit, the homeowner could lose the benefit of the tax-free rollover provision, or the $125,000 exclusion for taxpayers over 55, if the home is converted.

On the other hand, if the homeowner anticipates a loss on the final sale, a conversion might be worthwhile.

Calculating gain or loss may be tricky. If a homeowner deferred gain on a previous sale of a residence, the tax basis of the new residence is the same as the cost of the original home purchased, not the cost of the latest home.

If a gain is anticipated, the rollover provision generally allows the homeowner to defer the gain if another home is bought within 24 months of the sale, and if the cost of the new house at least equals the selling price of the old house.

There also is an alternative exclusion if you are over 55. It is a one-time $125,000 exclusion that applies even if you don't buy another home.

Keep in mind that the home must be a principal residence and not investment property. The homeowner must be able to prove that the rental activity is only "temporary."

There are no clear guidelines. Rental on a month-to-month basis should qualify. A lease that runs one year or less may support a temporary rental. The homeowner also should be able to prove that he or she made attempts to sell the home, both before it was put up for rental and during the rental period.

If the home is expected to sell at a loss, that loss is normally not deductible. However, if the home is converted to an investment property through a long-term rental, and if no attempt is made to sell it, the loss should be deductible. In addition, as noted above, deductions in excess of rental income also should then be allowable.

It is important at the outset to calculate correctly whether a gain or loss can be expected.

If you expect a gain, you will usually want to show that the rental is "temporary."

If, on the other hand, you expect a loss, you will likely want to demonstrate that the rental is "permanent." If you do, you should be able to take advantage of the available tax breaks.

Tax lawyer Albert B. Ellentuck is a partner in the Washington law firm of Colton and Boykin. Readers should see tax and legal advisers on specific cases.