One option for a retiree or couple is to rent their house instead of selling it. The easy way out is to sell a big house that may be a burden for an older couple, buy a smaller house or condominium with part of the cash, and invest the rest for income.
If you meet certain requirements, mainly having lived in the house as your personal residence for three of the past five years, you are entitled to exempt up to $100,000 of the long-term capital gain when figuring income tax on the sale. While there are many reasons for selling, some good reasons remain for not selling but renting the house for income that is sheltered from income tax.
Renting your house can be likened to a small business. You sell the opportunity to live in your house for a price -- called rent. This is your gross income from the business. As in any business you are entitled to deduct all "usual and necessary" expenses from the gross to arrive at net income. Included among expenses are taxes, insurance, maintenance, and depreciaation. If you still have a mortgage loan on the property, you can deduct the interest on the loan. Interest and taxes would be deductible in any case, but maintenance and depreciation may also be deducted because the house is income-producing property.
Depreciation is the key, because it is a noncash expense. That is, depreciation is an allowable expense even though no cash changes hands. Depreciation is your opportunity to get back the capital in the house over a period of 25, 30, or more years.
Suppose your house (excluding land) is worth $100,000, with an expected life of 25 years. To regain the full cost of the house, you could depreciate the $ 100,000 on a straight-line basis of $4,000 each year. The $4,000 is your depreciation expense. When added to other allowable expenses (taxes, insurance, maintenance, and other), your total could exceed gross rental income. Any excess can offset other income to reduce income taxes.
Using the example again, the $100,000 house might rent for $500 a month or $6 ,000 for the year. Taxes, insurance, maintenance, and miscellaneous expenses might total $3,000. Depreciation would add another $4,000. Total expenses of $ 7,000 exceed rental income by $1,000. Two elements of tax-sheltered income are involved. Since $3,000 of out-of-pocket expenses is paid out, $3,000 of income remains to be spent for living expenses or for any other personal purpose. This
But $1,000 of the allowable depreciation remains as an excess of expenses over income. By deducting this loss against your other income from whatever source -- personal service or investment income -- you have sheltered $1,000 from taxes.
Not all of this tax-sheltered income escapes, however. As noted in these columns before, the Internal Revenue Service expects to get at least one bite out of every dollar of income. Tax planning aims to keep that one bite as small as practicable. Note that over 25 years of the example, the $100,000 house is fully depreciated. That means the effective cost basis of the house is zero. If you sell the house with a zero basis, all of the sale price is reported as a long-tern capital gain. Currently 40 percent of long-tern capital gain is reported for payment of income taxes at ordinary rates. But paying tax on 40 percent is better than paying tax on 100 percent of income, and that is the main reason for converting as much income as possible to long-term gain.
This example and these figures are for illustration only. You should consult your accountant or attorney for specific advice applicable to your situation.