Many homeowners consider turning their primary residence into a rental property, whether to generate additional monthly income or to benefit from long-term property appreciation. While this can be a financially rewarding decision, it's important to understand the tax implications before moving forward.
Why Turn Your Home into a Rental?
Let’s say you bought a home, lived in it for a few years, and are now looking to upgrade to a larger house. Rather than selling your current home, you might be tempted to keep it as a rental property, hoping to build equity and earn passive income. That strategy can make sense; rental properties can offer consistent cash flow and appreciate overtime.
Other reasons homeowners choose to convert their homes into rentals include:
- Creating a long-term income stream for retirement
- Being in a desirable or appreciating real estate market
- Using rental income to help offset the cost of a new mortgage
Why It Might Not Be the Right Move
Owning a rental property isn't always as passive, or profitable, as it seems. Being a landlord comes with responsibilities: finding reliable tenants, managing maintenance and repairs, navigating local landlord-tenant laws, and dealing with potential vacancies.
Also, real estate is illiquid, meaning it can’t be quickly converted into cash. Unlike stocks or mutual funds, selling a property takes time, involves transaction costs, and may not align with your financial timeline. If you need funds urgently or aren’t prepared to take on the long-term commitment of being a landlord, renting out your home may not be the best route.
Understanding the Primary Residence Exclusion
One of the most important tax considerations is the Primary Residence Exclusion under Internal Revenue Code (IRC) Section 121. This exclusion allows homeowners to avoid paying capital gains tax on the sale of their primary residence, up to $250,000 for single filers and $500,000 for married couples filing jointly.
To qualify, you must have:
- Owned and lived in the home as your primary residence for at least two of the last five years before the sale, and
- Not claimed the exclusion for another home within the past two years.
The two years of ownership and use do not need to be consecutive. However, if you convert your home into a rental and keep it that way for an extended period, you will no longer meet these requirements, eliminating your eligibility for the exclusion.
Important Note: There are additional limitations on the exclusion for periods of non-qualified use, which refer to times when the property was not used as your primary residence. These can reduce the portion of the gain that’s excluded. It is important to work through the specifics of your situation with your Financial Advisor and CPA.
An Example
Let’s explore a visual of the benefits of taking advantage of the Primary Residence Exclusion. In this example, I will assume the individuals are married and filing jointly, meaning they qualify for up to $500,000 of exclusions.
| Amount of Other Income | $200,000 | |
| Exclusion Amount | $500,000 | |
| 15% Fed Tax Bracket | $400,050 | $400,050 x 0.15 = $60,008 |
| 20% Fed Tax Bracket | $99,950 | $99,950 x 0.20 = $19,990 |
| Net Investment Income Tax | $450,000 | $450,000 x 0.038 = $17,100 |
| MT State Tax | $20,500 | |
| Value of Primary Residence Gain Exclusion | $117,598 | |
The Net Investment Income Tax is a 3.8% tax on your investment earnings if your modified adjusted gross income exceeds certain thresholds.
This is $117,598 of taxes that you will not pay if you sell your primary residence while it still qualifies for the exclusion but will have to pay if you sell the house three years after converting it to a rental property.
If you’re considering investing in a rental property, a more tax efficient move may be to sell your current home first, take advantage of the Primary Residence Exclusion, and then use the tax-free proceeds to invest in a new rental property. Since you purchased a new property, not only will you have benefited from the capital gains exclusion, but you will also start with a higher tax basis on the rental property. This will create more tax deductions for depreciation expenses and reduce the taxes if you sell the rental in the future. If you decide to convert your home into a rental property before selling it, you will give up the ability to claim this exclusion if you rent for longer than three years, and that money will be lost forever.
Selling vs. Renting: What's Right for You?
For many homeowners, selling and taking advantage of the full exclusion will likely be more beneficial than converting the property into a rental. This could:
- Allow you to unlock tax-free gains to put toward your next home
- Avoid the complications and responsibilities of managing a rental
- Provide a clean slate and stronger liquidity
- Allow you to invest the proceeds from the gain exclusion in a new rental property
If you’re not committed to being a landlord for the long term, selling might be the more flexible and less risky option.
Consider Other Investment Alternatives
If your goal is to invest in the equity from your current home, there are other potentially better-suited options. Diversified portfolios comprised of investments such as stocks, bonds, or funds may offer:
- Greater liquidity
- Lower management responsibilities
- Access to different risk/reward profiles depending on your goals
- The ability to diversify
- Truly passive investments that can provide sustainable income
These alternatives can be a good fit if you're looking for growth or income without tying up your money in a single, illiquid asset.
Final Thoughts: Make an Informed Decision
Turning your home into a rental can be a smart financial move, but only if it aligns with your goals, lifestyle, and capacity to take risks. Carefully weigh the benefits of rental income against the tax implications, landlord responsibilities, and potential loss of the Primary Residence Exclusion. Whether you sell or rent, understanding ownership rules, exclusion limits, and non-qualified use application will help you make the best decision for your financial future. At CoCreate Financial, we walk through these decisions with our clients so that they can confidently move forward with a plan that fits their specific situation and equips them for the things that matter most to them.
Be sure to consult with your tax advisors, financial professionals, and legal counsel when making decisions regarding your individual situation.
