Have clients ready to retire and rent their family home? As a tax professional, you are critical in guiding them through the tax implications of converting a personal residence into a rental property. This can be a lucrative way to put unused assets to work, but it comes with important tax considerations, particularly regarding basis calculations and depreciation.

Determining the basis for a converted rental property

The basis of a rental property is essential in determining depreciation deductions and capital gains when sold. Generally, the basis of any asset includes the original purchase cost plus acquisition expenses, such as closing costs or commissions. These costs increase on an adjusted basis if improvements have been made, like a new roof, siding, or kitchen upgrades.

When a client converts a personal home into a long-term rental, the property is considered a business asset, and the basis calculation shifts. At the time of conversion, the basis is the lesser of the adjusted basis or the fair market value (FMV) on the conversion date. If the property was inherited or received as a gift, IRS rules differ in determining the basis. IRS Publication 551, Basis of Assets, provides guidelines on calculating basis when converting personal property to business use.

Claiming depreciation on a rental home

Once the property is a rental, it becomes eligible for depreciation deductions, a key tax benefit for landlords. IRS Publication 946, How to Depreciate Property, outlines depreciation methods and recovery periods. The modified accelerated cost recovery system (MACRS) is commonly used, but the straight-line method is also available. Residential rental property has a 27.5-year recovery life using the straight-line method.

Tax professionals should remind clients that depreciation starts when the home is placed into service as a rental, not when it was originally purchased. If improvements are made after the conversion, those costs may be added to the basis and depreciated separately. IRS Publication 527, Residential Rental Property, details the depreciation and expenses that can be deducted when renting a house for profit.

Key steps for tax professionals when converting a home to a rental

1. Determine basis: The converted basis is the lesser of the adjusted basis or FMV at the time of conversion. Refer to Publication 551 for more details.
2. Select depreciation method: Based on property classification, use MACRS or straight-line depreciation. Publication 527 provides guidance on depreciation and allowable deductions.
3. Track rental expenses: Keep detailed records of allowable deductions, including property taxes, mortgage interest, insurance and maintenance.
4. Consider partial business use: Depreciation and expense deductions must be allocated accordingly if the home is not used exclusively for rental purposes.
5. File Form 4562, Depreciation and Amortization: Report depreciation and amortization correctly on the client’s tax return.

Why clients need a tax professional

Converting a home to a rental property can provide great financial benefits, but the tax implications can be complex and costly if done incorrectly. NATP members stay informed on the latest tax regulations and are well-equipped to guide clients through basis calculations, depreciation strategies and IRS compliance.

If your clients are considering renting out their home, remind them that having an NATP tax professional ensures they make smart financial decisions while maximizing their tax benefits. Proper tax planning now can save them significant money and avoid issues in the future.

A taxpayer’s filing status – married filing jointly, married filing separately, head of household (HOH), qualifying surviving spouse or single – significantly impacts their tax liability and benefits. It determines whether they need to file a return, the type of return required, the standard deduction amount, the credits they can claim and the total tax they owe.

Below, you’ll find a few of the top questions from a recent webinar on the topic and their accompanying answers. If you choose to attend the on-demand version of this webinar, you can access the full recording and the entire list of Q&As.   

Q: A girlfriend that lives with her boyfriend, and she doesn’t work. Can the boyfriend use the HOH filing status?

A: No, the boyfriend cannot use the HOH filing status. Even though the girlfriend could be a qualified relative, she is not a qualifying person for purposes of the HOH filing status.

Q: Does a non-resident alien (NRA) spouse need a Social Security number (SSN)?

A: They need either an SSN or an ITIN to file as MFJ or MFS.

Q: If they have an SSN, does that mean they are a U.S. citizen?

A: Not always. Some SSNs are not for working purposes, and some of them are issued to green card holders, so it is always good to question the client of their status for purposes of filing a tax return.

Q: Can one spouse file as MFS and the other spouse file as HOH at the same address?

A: No, you cannot file HOH if you are married. To file HOH, you have to be considered unmarried as of the end of the tax year. One of the qualifications is that the taxpayer did not live with their spouse for the last six months of the year.

To learn more about determining filing statuses for your clients, you can watch our on-demand webinar. NATP members can attend for free, depending on membership level! If you’re not an NATP member and want to learn more, join our completely free 30-day trial.

Question: Jim and Sarah are married and filing a joint tax return in 2024. Their modified adjusted gross income (MAGI) was $237,000. The couple finalized the adoption of a child with special needs in 2024 and have qualified adoption expenses (QAEs) of $10,000. Is their adoption credit limited to $10,000 in 2024?

Answer: No, Jim and Sarah can take the maximum adoption credit of $16,810 in 2024 for a child with special needs, regardless of the QAEs they paid. However, other specific criteria must be met to take the adoption credit. Married taxpayers must file a joint tax return. Their MAGI must also be below $252,150 in 2024 to receive the full adoption credit amount. Finally, the adoption must be final in the year the adoption credit is claimed.

The adoption credit is a non-refundable tax credit. Therefore, the amount of credit cannot exceed the taxpayer’s tax liability. Any unused adoption tax credits can be carried forward for up to five years.

The adoption tax credits are reported on Form 8839, Qualified Adoption Expenses, Part II, Adoption Credit, which flows to Schedule 3 (Form 1040), Additional Credits and Payments, Line 6c, Adoption Credit. Attach Form 8839.