Tax Changes: Sell Your Property or Convert to a Rental Property? What’s Right for You?

By Joe Erickson, CPA and Viridian Shareholder

Recent changes to tax law can have a significant impact on decision-making in the current real estate environment. This article describes some of the major changes, and it will hopefully help you decide what to do with your home if/when you decide to no longer live there.

Tax Changes

In a nutshell, it is now less beneficial, from a tax standpoint, to personally own real estate (e.g., your home or a vacation property) than it was prior to 2018.  One of the primary reasons is the increase in the “standard deduction” (the deduction everyone gets without having to itemize).  Specifically, the standard deduction has been raised to $12,000 for individuals and $24,000 for married couples.  Since the only advantage of itemizing is the extent to which your deductions exceed the standard deduction, these higher thresholds mean that you need considerably more deductions than before to receive any tax benefit from them.

Making matters worse, there are new restrictions on the amount you can deduct for certain expenses.

  • First, you cannot deduct more than $10,000 in state-induced taxes (that includes personal property taxes, vehicle excise taxes, state income tax, etc.). In other words, you might not be able to deduct all of your property taxes (if they—together with other state taxes—exceed $10,000). 
  • Similarly, you can now only deduct mortgage interest on personal real estate for $750,000 of mortgage debt; and
  • You can no longer deduct any interest on Home Equity loans.

Taken together, these changes mean that much of the tax benefit of personally owning real estate—which heretofore mostly came from deducting property taxes and mortgage interest—is now gone.  As a result, the question of whether, and the extent to which, personally owning real estate makes financial sense depends less on tax savings, and more on other factors, such as how much it appreciates in value. 

Selling Your Home versus Renting it Out

In light of the above changes, if/when you’re considering moving, you might be wondering if it makes more sense to sell your home (or vacation property) or keep it and rent it out as an investment property.  The answer again depends partially on how much you think the value will increase in the future.  But there are tax considerations to both sides of the equation.

If you sell your “primary residence,” the tax law still allows you to take a one-time (once in your lifetime) exclusion of part of the resulting capital gain.  If you qualify, meaning you must have lived in the house for two of the previous five years, you as an individual can exclude up to $250,000 of capital gain when you sell. For a married couple, that amount is $500,000.  This exclusion was the same prior to the new tax law, but it still impacts the decision to sell versus rent the home out because you can’t use the exclusion if you convert your home to a rental property.

If you can use most or all of the above one-time capital gains exclusion, it may make more sense to sell your home and purchase a new rental property instead.  Financially, this allows you to enjoy both the exclusion and the benefits of owning rental property, the “best of both worlds” from a tax standpoint.  Of course, you also need to consider the costs of selling your home and buying a new property to rent out, as well as how long you intend to keep the property in the future.

Investing in Real Estate (Rental Property)

The relative benefits of investing in real estate are somewhat location dependent. In different parts of the country (and even different parts of your own area), you can charge higher or lower amounts of rent as a percentage of the cost of the rental property.  In many parts of the Midwest, for instance, the rent paid is very high relative to the cost of the real estate. That makes it highly advantageous for landlords, who get a lot more for their dollar than they would in much “hotter” real estate markets (e.g., New York City, San Francisco and Seattle).

One benefit of rental real estate, unlike personal real estate, is that it is considered a rental business, and you can, therefore, deduct all property taxes and mortgage interest as business expenses, regardless of the amount.  Recent changes to tax laws have added one new advantage, though.  The new tax law allows you to reduce the taxable income (profit) from your rental real estate by taking a new deduction.  This deduction is the lesser of 20% of the net income from a rental property, or 2.5% of the unadjusted cost basis (the original purchase cost, without reduction for depreciation deductions) of the “real property” (i.e., the structures only, excluding the value of the land).

Let’s look at an example.  Let’s say you own a rental property that has a net profit, i.e., rental income minus all expenses, of $20,000.  If the property was originally purchased for $250,000, $200,000 of which was attributable to the home itself (excluding the portion of its value attributable to the land it’s on), you would be allowed to deduct from that $20,000 either 20% of $20,000 ($4,000) or 2.5% of $200,000 ($5,000).  In this case your deduction would be $4,000 (20% of net income) since $4,000 is less than $5,000.  Thus, the amount that is taxable would be $16,000 ($20,000 – $4,000).

Think It Through, Get Help if Needed

The above includes some undeniably confusing concepts.  Adjusting to the new environment created by recent changes in tax laws can seem overwhelming.  Thus, you might benefit from the guidance of a financial advisor who has the in-depth knowledge to help you make strategic decisions, maximize your real estate success, and integrate real estate decisions into your overall financial and investment plans.

Viridian is an SEC Registered Investment Advisor (RIA) with clients across the United States. Viridian offers financial planning, asset management, employee benefits advice, as well as tax services through its sister company, Viridian Tax and Accounting. Joe Erickson is a Certified Public Accountant (CPA) and Viridian shareholder who works for Viridian Tax and Accounting.

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