Thinking of Converting Your Primary Residence into a Rental? Here’s Something You Should Know

Typically, people sell their homes when they move, taking the equity they’ve built in one house and applying it to the next. But that isn’t always the case. Some savvy homeowners convert their primary residences into investment properties, and while this approach can be a great way to generate additional income and build valuable equity over time, becoming a landlord is not without its challenges.

One key variable to consider before turning your former home into a rental property is your new primary residence. After all, you will need a place to live when you move. Remember to contact a mortgage broker and make sure you qualify for another mortgage prior to finalizing your decision. The bank could consider the income the new rental property will generate when deciding whether to grant a new loan, but that is not always the case.

Before you consider converting your home into a rental property, you should ensure that it is in adequate condition to attract tenants. This entails repairing any major damage and ensuring that all systems in your home (e.g., plumbing, electrical, HVAC, etc.) are in good working order.

Once the house is ready, you will need to find tenants. Marketing your rental property online is a great way to reach a wide audience of potential residents. You should take high-quality professional photos and make sure to leverage the powers of social media to attract the best tenants. It is also advisable to hire a realtor to list and show your property and have them conduct preliminary screenings of potential tenants on your behalf.

Whether you hire a realtor or list the property yourself, once the tenants are settled, you will need to manage them. This includes everything from collecting rent to handling repairs and emergency maintenance issues. If you don’t think you can handle this on your own, there are property management companies that can do it for you…for a fee. These types of companies often charge a percentage of the rent collected each month as the fee for their service—ranging between 8% to 10% on average.

Before signing tenants to a lease, it is important to iron out all the legalities. In addition to drawing up a formal lease, you must obtain the appropriate licenses and permits required by your state and local municipality, as it is common for local governments to require a permit for residential properties that operate as rentals for safety reasons.

It is equally important to make sure your homeowner's association (HOA) allows for renters. If the neighborhood is governed by an HOA, there may be rental restrictions in place. Since you agreed to follow the HOA rules when you originally purchased the house, it is important to revisit them to prevent being fined.

You will also need to speak with your insurance company and switch your current homeowner’s insurance to rental property insurance. Surprisingly, in some cases, switching to rental property insurance lowers your rates, as it covers the building but does not cover renters’ personal items.

In addition to rental property insurance, it is also a good idea to request personal liability insurance, which will help protect you from being sued by a tenant. You should always be prepared to deal with the occasional problematic tenant. Even if you do everything right, there will be a chance that you end up with a renter who does not pay their rent on time, causes damage to your property, or worse.

You must also navigate the complicated tax rules when converting a personal residence into a rental property. Suffice it to say, the year you make the conversion, taxes on the property will be handled differently. You will need to document everything and maintain meticulous records.

While you will have to report the income from the rental as taxable income, you may also be allowed to deduct qualified expenses for maintaining the property and take a depreciation deduction. In many cases, you can use the depreciation and any other allowable deductions to offset the income the rental will generate each year.

Should you eventually choose to sell the converted property, the formula for calculating taxes on any gain (or loss) received will be different from that of a primary residence. It is important that you take note of the property’s fair market value on the date it was listed for rent so that you can track its original basis and the cost of any major improvements made during the rental period.

Finally, if you are planning to convert your primary residence into a rental property, you should speak with a tax professional to discuss all of the possible implications. There may be other factors to take into consideration or other opportunities that you are not familiar with that will be helpful to know about prior to finalizing the decision.

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Malcolm Ethridge, CFP® is the Managing Partner of Capital Area Planning Group based in Washington, DC. He is also the Managing Partner of Capital Area Tax Consultants. 

Malcolm’s areas of expertise include retirement planning, investment portfolio development, tax planning, insurance, equity compensation and other executive benefits. 

 Disclosures:

The information provided is for educational and informational purposes only, does not constitute investment advice, and should not be relied upon as such. Be sure to consult with your legal advisors before taking any action that could have tax and legal consequences.

Investments in securities and insurance products are:

NOT FDIC-INSURED | NOT BANK-GUARANTEED | MAY LOSE VALUE