Sometimes moving into your rental makes sense. A move could reduce your monthly mortgage payment, give you the time to finalize long-term plans or minimize your capital gains as you begin to think about selling the property. It could also allow you to downsize or provide you more space for a growing family if you need it.
There are many reasons why you might want to move into your investment property, but in doing so, you change its status from a rental to a primary residence. Here are four things you need to be aware of before you make the move.
Whenever you purchase a property, the first thing you should do is set up a limited liability corporation (LLC) and quit-claim the property to the LLC, according to Craig W. Smalley, an Orlando-based tax adviser admitted to practice before the Internal Revenue Service. This protects your other assets in the event that someone sues for damages resulting from an incident at the property.
For example, if your tenant falls and you own the property, he can sue you personally for damages, putting any other rental properties or assets you personally own at risk. On the other hand, if the LLC owns the property, the tenant can only be awarded damages totaling the amount of the assets owned by that LLC, which should be that one property. He can’t go after your personal assets or other rental properties.
Once you decide to make your rental property your primary residence, though, you want to establish ownership, especially if you intend to avoid capital gains tax. To do this, quit-claim the property from your LLC back into your own name. (Of course, if you move out later and want to make the property a rental again, you’ll want to quit-claim it back into the LLC for liability protection.)
The change in ownership also affects insurance. A landlord’s policy typically covers the physical building and indemnifies the landlord against liability. It does not cover the occupant’s belongings. (That’s why it’s important for the renter to have renter’s insurance.) If you plan to move into your rental property, ditch the landlord’s policy and purchase a homeowner’s policy instead.
A rental property entitles you to take specific business deductions. Once you turn your rental into your primary residence, those business deductions are replaced by homeowners’ deductions. In some cases, such as with mortgage interest deduction, the effect is minimal. When the property is a rental, the deduction is claimed on a Schedule E and subtracted from your rental income, and when the property is your primary residence, it is claimed on a Schedule A and subtracted from your adjusted gross income. The same applies to mortgage insurance premiums and property taxes.
Just keep in mind that if you move in the middle of the year, the property will be considered a rental for that first part of the year and a personal residence for the remainder of that year, so the deductions will need to be prorated. You’ll end up filing both a Schedule E and a Schedule A form, but you’ll be able to take the entire deduction.
That’s not the case with maintenance and repairs. For a rental property, you can deduct costs incurred to maintain, repair and improve a property. For your personal residence, you cannot. But you should definitely keep track of these expenses, because when you do go to sell your property, you can use them to reduce your capital gains if you need to, says Brian Davis, director of education for Spark Rental.
When a property is a rental, you can depreciate, or write off, a portion of its actual cost (what you paid for it) each year for 27.5 years. Once you move in, though, that write-off goes away, and when you sell the property, you must “recapture” these deductions, meaning you have to report them to the IRS and pay a tax of up to 25 percent on the depreciated amount.
Don’t think you can avoid the tax by not claiming the depreciation while the property is a rental. The IRS automatically applies the recapture when you sell the property, whether you claimed it or not.
Calculating the ramifications of depreciation after making a rental property your primary residence can get complicated, especially in light of a 2009 rule that requires looking at qualified versus nonqualified use. Before making the move into your rental, consult your tax professional.
Although Smalley has never seen a case where moving into a rental property was a bad decision as far as taxes were concerned, individual circumstances vary.
“You should definitely consult with a tax professional,” he advises.
Home Sale Exclusion
With a rental property, you’ll pay capital gains on your profit when you sell your property. (For most people, the rate is 15 percent. For higher-earning investors, the rate may be 20 percent.) However, as a general rule, you can avoid some, if not all, of the capital gains tax by moving into your rental and making it your primary residence for at least two of the five years leading up to its sale.
IRS Publication 523 goes into depth on ownership and use qualifications, but in general, if your property is your primary residence for at least two of the last five years, you don’t have to pay capital gains on amounts up to $250,000 for a single person and $500,000 for a couple filing jointly, says Smalley.
Again, you’ll want to discuss this with a tax professional before you make the move to see how the home sale exclusion applies to your specific circumstances.
“The question you need to ask yourself before you move is how long you are going to be there,” he adds. “If you’re going to be there less than two years, it’s not really going to be worth it.”