You can deduct expenses for your rental home on your return even if you don't have tenants as
long as you are actively seeking tenants. One way to document that you are actively seeking
tenants is to clip out and save an ad in the newspaper showing that your rental home is available.
Deducting Rental Losses
You can deduct up to $25,000 of rental losses on your tax return if your adjusted gross income
is less than $150,000. If you are renting to a family member, you can deduct your rental loss if
the family member is paying a fair rental price and uses the home as their principal residence.
This fair rental price can be as low as 80% of the amount of rent you would charge a non-family
member since the courts have ruled that there are less risks with renting to family
members.
You are not limited to $25,000 in rental losses on your tax return if you are a real estate
professional. If you spend more than one half of any job or business related time doing your real
estate business and spend more than 750 hours on your real estate business, then you are a real
estate professional.
Evaluating Your Situation
When evaluating whether to acquire or keep a rental property, you should look at the cash flow
potential. Most rentals show a tax loss since depreciation of the rental is usually a significant
deduction on the tax return. However, many rentals still have a positive cash flow. If the
amount of rental income and the tax benefit of the rental loss aren't going to be enough to cover
operating expenses such as the mortgage payment, property taxes and insurance, you may reconsider
acquiring or keeping the rental.
Besides cash flow, other factors in your decision would be what
you expect the appreciation of the home will be and whether you could get a better return on
investment if your cash was invested elsewhere.
Always take depreciation on your rental home. Some people don't want to bother taking
depreciation on their home if they are planning to rent their home for a year or two before
returning and making the home their principal residence again. However, the IRS considers
depreciation to be taken on your rental home for the period it was rented whether or not you take
the depreciation on your tax return. So when you eventually sell the home, gain needs to be
recognized to the extent of any depreciation taken (or what should have been taken).
Sale Of Residence Exclusion
If you
sell your principal residence and qualify for the exclusion of gain, you do not have to recognize
any depreciation that you took on the home prior to May 6, 1997. For example, you rented your home
between 1992 and 1995 while working out of state. You moved back into the home in 1995 and
eventually sell the home in 2005. The gain on the sale of the home is less than $250,000. You
don't have to report anything on your 2005 tax return since all of the depreciation that you took
on the home was taken prior to May 6, 1997.
Pay no taxes on the sale of your rental home by converting the rental home into your principal
residence. If your rental home is your principal residence for two out of the previous five years
before the sale of the rental, you qualify for the $250,000 ($500,000 for married filing jointly)
exclusion of gain on the sale of your residence. Better yet, any depreciation taken on the rental
before May 6, 1997 does not have to be recaptured as income when the rental is sold.
For example, John Doe has owned a rental home for the past thirty years that he originally purchased for
$20,000. The rental home has been fully depreciated so the home's basis is zero.
John moves into
the rental home and uses it as his principal residence for two years before selling the home for
$200,000. Since he qualifies for the exclusion, all $200,000 of gain he would have had to
recognize as capital gain and ordinary income is excluded from income. He pays zero taxes on the
sale instead of the $41,000 or more in taxes he would have paid if the rental home did not qualify
as his principal residence.
In order to qualify for the $250,000 exclusion, a home must be the taxpayer's principal residence.
If you own multiple residences, simply living in a home may not be enough to prove that the home is
your principal residence. Physically occupying a home is just one factor to be looked at. Other
facts and circumstances are the address shown on your tax return, your voting place, the address
shown on bank statements and other documents, car registration, location of children's school,
location of your business, driver's license, and club and church membership.
Basically the more
facts and circumstances that you can show as proof that the home you sold was your principal
residence, the stronger your case is for using the sale of principal residence exclusion.
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