for_rentThe cornerstone of any wise investment decision is knowledge. It is imperative that one understands the tax consequences of any investment. Whether it is the cost of property taxes, sales taxes, or the income tax implications of your transaction, knowledge is key.

If you have decided to move to another residence, but find it difficult to sell your present home one way to weather a soft residential market is to rent out your present home until the market improves. If you are thinking of taking this step, you no doubt are fully aware of the economic risks and rewards. However you also should be aware that renting out your personal residence carries potential tax benefits and pitfalls.

Rental activities generally fall into the category of “passive” activities. This means that rental losses you incur can be deducted currently only against passive income, and not against nonpassive income such as your wages or investment income.

However, if you “actively participate” in the residential rental activity, you may be able to deduct a loss of up to $25,000 in a tax year against nonpassive income. You actively participate in the rental activity if you make key management decisions such as approving new tenants, deciding on rental terms, approving capital expenditures. You also can show active participation by arranging for others to improve services. You need not have regular, continuous and substantial involvement with the property. Losses that aren’t allowed because of the amount limitations don’t just disappear. They are carried forward and can be deducted against nonpassive income in future years if you can continue to actively participate in the rental real estate activity that generated the losses, subject to the $25,000 limit.

Some homeowners who bought at the height of a market may ultimately sell at a loss. In such situations, the loss is available for tax purposes only if the owner can establish that the home was in fact converted permanently into income-producing property, and isn’t merely renting it temporarily until he can sell. Here, a longer lease period helps an owner. However, if you are in this situation, you should be aware that you probably won’t wind up with much of a loss for tax purposes. That’s because basis (cost for tax purposes) is equal to the lesser of actual cost or the property’s fair market value when it’s converted to rental property. So if a home was bought for $300,000, converted to rental property when it’s worth $250,000, and ultimately sold for $225,000, the loss would be only $25,000.

The original article can be downloaded here.

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