For homeowners who need to move or downsize and are unlikely to sell their home for a price they want, renting out the property is an option to consider.
Renting has some advantages, including rental income that can offset the costs of a mortgage, real estate taxes and insurance. Also, renting buys a homeowner some time to put the property on the market later when it might fetch a better price. If you do rent, check with your home insurance company to make sure you're still covered for damages.
Home rental tax breaks
And when you rent your home and collect rental income, you can also gain a slew of tax benefits. For example, you can deduct most of the out-of-pocket expenses reasonably related to owning and managing your property. This includes deducting your mortgage interest payments, home insurance premiums, property taxes, maintenance, repairs and cleaning services. You can even deduct the cost of travel and local transportation expenses incurred for maintaining and managing the property, as well as collecting the rent. Rental income and related expenses are reported on Schedule E, Supplemental Income or Loss.
Then there's the deduction for the so-called "depreciation cost." This is a deduction for a portion of the property value you take as a deduction each year.
To calculate the applicable depreciation deduction, you should first get an appraisal or a written statement from a qualified real estate professional stating the current value of the building, excluding the value of the land. Next, you'll use the lesser of what you paid for the property or the appraised value as the base for calculating depreciation. Then divide the base amount by the recovery period for residential property, which is 27.5 years. The result is the amount you can take as a depreciation deduction each year.
For example, if the depreciation value of your home is $250,000, then divide that by 27.5 and you'll get $9,090. That's the annual depreciation deduction you can take each year. See IRS Publication 527, Residential Rental Property for more details, including a description of all the rules that apply.
One of the tax benefits of renting real estate is the deduction of rental losses against other income. If your rental expenses exceed rental income, then you may be able to take a tax deduction of up to $25,000 against other income, including salary. This tax break is available as long as your adjusted gross income (AGI) doesn't exceed $100,000 per year (applies to single and married filers). For those with income above $100,000, this tax break is gradually reduced and phases out completely when your AGI exceeds $150,000.
Depreciation deduction and recapture
Before you rent your home, you should also be aware of how renting it could affect your taxes when you later sell it. If you lived in the property for at least two years and then rented it out for less than three years, you may be able to use the provision that allows you to exclude up to $500,000 of gains tax free. But you will still have to pay income tax on the total amount you claimed for depreciation while renting it out. This means if you claimed $9,000 annually for depreciation for the past five years, then you'll have to report $45,000 as income due to this depreciation-recapture rule.