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I'm considering the net monthly cost of moving from a mortgaged home to a rental, and converting my current primary residence to a rental property.


(Note: the reason for renting instead of selling is that the mortgage is underwater, and if I can afford to continue to pay for it, I would like to.)


Right now I can deduct all the interest I pay on the mortgage, so its cost to me is essentially reduced by the amount of the tax bracket I am in.

If my understanding is correct, then rental income for my own property will count as ordinary income on my taxes, while the rent I would pay is not deductible in any way (ouch).

So, given some very rough example numbers, I might expect a cash flow change like this:

Before

  • $1500/month mortgage, of which $1000/month is interest
  • 25% tax bracket
  • Yearly mortgage total of $18000
  • Less $3000 refunded for $12000 in deductible interest
  • Net housing expenses of $15000 (two months free!)

After (Potential scenario)

  • Rent out current house for $1400/month
  • Pay for an apartment at $1200/month (net difference of $200 cheaper per month)
  • Net yearly residence rental expenses $14400
  • Net yearly rental income of $16800
  • We'll say that I have $150/month of rental property maintenance that reduces my taxable rental income, in addition to the $1000/month of interest) - $13800/year in expenses, which makes $3000 in taxable rental income
  • Net yearly housing costs of ($18000 mortgage - $16800 income) + $14400 + (25% * $3000) = $16350

Unless I'm missing something, I'm now living in a place that is $300 per month cheaper, but my housing costs are $1350 per year higher, because of the loss of taxable interest and new taxes on rental income.

For reference, this is not an investment calculation but rather an expense calculation to make sure that I understand correctly how to calculate my yearly living expenses if I decide to become a landlord in one location and a tenant in another.

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For both before and after, you need to account for property tax. That's not mentioned here. As others mentioned, when you put a property into service as a rental, you depreciate the value of the building over 27.5 years. This helps with cash flow, but is recaptured on sale, i.e. it lowers your basis and when you sell, you probably will be taxed on what you took and then some. Last, your mortgage is $500 principal, so even if you are out of pocket a bit, you bottom line will still improve by this amount each month even if your flow is break even. –  JoeTaxpayer Jul 21 '12 at 0:43
    
If you can rent the house out for $1400 a month I would assume the home would appraise at around $140000*.9=126000 if this is the case you'd be writing off depreciation of (126000-lot value)/27.5 years annually. As mentioned elsewhere if you move back into the house for a couple years prior to selling you can avoid the reduction in basis that will occur as you take depreciation. I had a similar situation and the 2 of 5 years scenario came from my accountant. –  Elder Geek Oct 21 at 23:15

3 Answers 3

The rental income is indeed taxable income, but you reduce the taxable portion of it by deducting expenses (including mortgage interest, maintenance, insurance, HOA, real estate tax, and of course depreciation). Due to the depreciation, you may end up breaking even, or having very little taxable income.

Note that when you sell the property, your basis is reduced by the depreciation you were allowed to deduct (even if you haven't deducted it for whatever reason), and also the personal residence exclusion might no longer be applicable - i.e.: you'll have to pay capital gains tax. You will not be able to deduct a loss though if you sell now, so it may be better to depreciate it as a rental, rather then sell at a loss that won't affect your taxes. Also, consider the fact that the basis for the depreciation is not the basis you currently have in the property (because you're under water). You have to remember that when calculating the taxes.

This is not a tax advice, and you should seek a professional help.

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You are assuming 100% occupancy and 100% rent collection. This is unrealistic. You could get lucky and find that long term tenant with great credit that always pays their bills... but in reality that person usually buys a home they do not rent long term. So you will need to be prepared for periods of no renters and periods of non payment. The expenses here I would expect could wipe out more than you can make in "profit" based on your numbers.

Have you checked to find out what the insurance on a rental property is? I am guessing it will go up probably 200-500 a year possibly more depending on coverage. You will need a different type of insurance for rental property.

Have you checked with your mortgage provider to make sure that you can convert to a rental property? Some mortgages (mine is one) restrict the use of the home from being a rental property. You may be required to refinance your home which could cost you more, in addition if you are under water it will be hard to find a new financier willing to write that mortgage with anything like reasonable terms.

You are correct you would be taking on a new expense in rental. It is non deductible, and the IRS knows this well. As Littleadv's answer stated you can deduct some expenses from your rental property. I am not sure that you will have a net wash or loss when you add those expenses. If you do then you have a problem since you have a business losing money. This does not even address the headaches that come with being a landlord.

By my quick calculations if you want to break even your rental property should be about 2175/Month. This accounts for 80% occupancy and 80% rental payment. If you get better than that you should make a bit of a profit... dont worry im sure the house will find a way to reclaim it.

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+1 good points. For $2175 did you estimate depreciation? OP didn't mention house value, but depreciation is still a chunk of change. –  JoeTaxpayer Jul 19 '12 at 15:10
    
@JoeTaxpayer - The 2175 is what he needs to run his business at a break even point in reality not tax wise. The government is going to get a chunk of that in taxes probably(even hopefully). Over time that number should come down(the break even) assuming good management and maintenance. But that is the number I would want to start to give my business a reasonable chance of success. –  user4127 Jul 19 '12 at 16:13
    
Just to clarify that 2175 number is the number where moving out of the house to rent it out starts to makes sense. Anything lower and I would expect that the hole the OP is in would get deeper so the entire idea loses appeal. If you can eliminate the mortgage that number drops drastically. –  user4127 Jul 19 '12 at 16:21
    
I'd point out - If the house is worth say $270K (just house, you don't depreciate property), there's $10K/yr of depreciation. $2500/yr after a 25% tax rate, just over $200/mo. It's subject to recapture of course, but is part of up front cash flow. –  JoeTaxpayer Jul 19 '12 at 17:56
    
@JoeTaxpayer - Are you entitled to 10% depreciation a year? When I am considering a business venture I look only at that income I can reasonably expect. If I can not count on that 2500 off my bottom line then I hate to bet my business on it. –  user4127 Jul 19 '12 at 18:37

You have some of the math right, but are missing a few things. Here's what I can offer - if I leave anything out, someone please expand or clarify.

  • You do have to report the rental income as normal income. Schedule E, I believe.
  • Rental income can be reduced by mortgage interest and maintenance costs (as you mentioned), but also by property tax payments, association fees, insurance costs, landlord expenses, and depreciation.

    • If you're already deducting your mortgage interest and property tax on Schedule A, these are not new deductions, so they won't provide additional help.
    • Yearly depreciation is (I believe) equal to market value divided by 27.5 (see comments for more info).
  • Note that if you don't live in the property for 3 years, you'll have to pay capital gains tax if/when you sell the house. You can live in it again for 2 of the last 5 years to avoid this.

  • Many people recommend only assuming you will get 10 months of rental income a year, to account for transitions between tenants, difficult in finding new tenants, and the occasional deadbeat tenant. This also adds a buffer for unexpected problems you need to fix in the house. If you can't at least break even on 10 months of income a year, consider the risk.

    • You should also understand that being a landlord can be real work, so you may also want to make sure you're making some money and not just breaking even, to cover the cost of your time. Some houses/tenants can require lots of attention (and of course they always need it on a Sunday night)! You can actually incorporate and pay yourself a "salary," but that's a whole other discussion.
  • I think there are also some cases where you need to repay depreciation amounts that you have deducted, but I don't know the details.

Renting out a house can be fun and profitable, but it's very far from a sure thing. I'd always recommend preparation and caution, and of course talking to professionals about the finances, accounting, and lease-writing. Good luck!

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Once property tax and depreciation are added to the mix, the property will generate a paper loss. What is the point of having a fake salary when the identical dollars the schedule E would list as the salary must be taken as ordinary income on the rest of the 1040? Besides, it's not a legal deduction. –  JoeTaxpayer Jul 18 '12 at 23:53
    
"If you're already deducting your mortgage interest and property tax on Schedule A, these two are a wash." -- I don't think so, because if you look at it that way, I'm getting $16800 in new taxable income in the IRS's eyes, when I'm not really - I'm still paying my own rent, and I'm paying a mortgage. –  NickC Jul 18 '12 at 23:55
    
Note: The first time depreciation is claimed it will not the value divided by 27.5 it will be prorated because of the partial year. –  mhoran_psprep Jul 19 '12 at 11:21
    
@NickC You're right; it's not a wash overall due to the new income, I guess I just meant you could deduct them before, and still can (though in a different way). I'll edit to clarify. –  Steven Jul 19 '12 at 17:09
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@JoeTaxpayer All I meant about the 'salary' was to acknowledge that being a landlord is a real job. If anyone's considering renting their property out, they should understand that it's not just passive income, and set the rent accordingly. I'll edit to clarify. –  Steven Jul 19 '12 at 17:14

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