Accidental Landlord: Don't Rent Out Your Home Until You Watch This!

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Today, we're discussing why you might not want to become an 'accidental landlord', and that is when you decide to rent out a property you own, that you originally intended to sell - typically after you bought another, new home. While this can sound like a great opportunity for extra income, there are some tax pitfalls you should be aware of. 


From a tax point of view, my number one reason why you might want to sell your home, and not rent it out, is that you’ll probably lose the generous capital gain exclusion. And when you decide to sell down the road, you could get hit with a capital gains tax.

You’ve probably heard about it. Section 121 of the Internal Revenue Code, allows for a generous capital gains exclusion. It’s an IRS rule that allows you to exclude from your taxable income, a gain of up to $250,000 from the sale of your principal residence. If you’re married filing jointly, then you get to exclude up to $500,000 dollars.

This rule lets people who sell their primary home, to put the proceeds from the sale into another home without having to pay taxes on the gain. Up to the previously stated limits, and as long as you qualify.

The main restriction on using the Section 121 exclusion is the ownership and use test. This requires that the taxpayer has owned the home and used it as a primary residence for at least 2 of the last 5 years. And the 2 years do not have to be consecutive.

For instance, a taxpayer could qualify for the exemption if the taxpayer lived in the home for a year, moved out for three years, and then used it again as a primary residence for the last year.

To me this is a big thing that is often overlooked. I’ve encountered my share of people who thought it would be a great idea to rent out their old homes after purchasing a new home. They didn’t consult with me or a tax professional for that matter.
A lot of these people became shocked to discover that upon selling the old home, turned rental property. They now were facing a capital gain, along with taxes due, when they sold.

So, why is this?

Well, you have the generous capital gains exclusion, which was lost. Remember, this only applies to primary residences that you lived in, two of the last five years.

Also keep in mind, while the property was a rental, the owner was able to benefit from a depreciation deduction. As you may know, when you sell the rental property, you have to give back or repay the depreciation deduction that you had previously taken or benefited from.

So, that’s my number one reason that you might not want to become an accidental landlord.

Now, there’s a lot more reasons like the challenges of being a landlord, and the management responsibilities. It's not just about collecting rent. You've got to handle tenant complaints, keep up with maintenance and repairs, deal with emergencies, and make sure you're ticking all the legal boxes.

You might be thinking, well, I'll just hire a property manager.

Sure, that's an option, but remember, that's an additional cost that will eat into your rental income.

Oh, and that rental income is taxable and the tax laws for landlords can be a real headache. You need to keep an accounting of your rental property income and expenses, and usually you have to hire an accountant to do your taxes, because they aren’t that straightforward anymore.

Also, there’s financial risk. As much as we love to dream about a constant stream of rental income… reality can sometimes hit hard. There might be periods when your property is vacant, or you could end up with bad tenants or missed rent payments.

Then there's property damage and the nightmare scenario of eviction proceedings, all of which can be very expensive. Not to mention other expenses like property taxes, insurance, and potential higher mortgage interest rates.

But it's not all about the money. Becoming a landlord also involves navigating a sea of legal issues. You'll need to comply with fair housing standards, landlord-tenant laws, and anti-discrimination laws - to name a few. Plus, if you've got an existing mortgage on the property, you might need your lender's permission to rent it out. Sounds complicated, right?"

And last, but definitely not least, is the emotional stress. We all hope for dream tenants who pay on time and treat our property with care and respect. But when that doesn't happen, dealing with disputes and property damage can take a real toll on your health.

Let me tell you a story about a friend of mine, named Mike. Mike thought it would be great to rent out his old house. He was looking forward to that extra income, and potential price appreciation. But he soon found himself dealing with late-night emergency calls about sump pump flooding, disputes over rent, and then there was a period of six months when his property was vacant. All of this while he was trying to balance his own job and family. Eventually, the stress and unexpected costs led Mike to sell the property. And to make matters worse, he got hit with a $35,000 capital gains tax bill.

So, it's definitely worth thinking twice before becoming an accidental landlord.

Just be aware that renting out a property isn't a passive income stream; it's an active business that comes with its own risks and responsibilities. So make sure you've got all the facts and maybe consult with a professional in advance to discuss your specific situation.

Engaging a tax professional can provide you with the expertise needed to navigate complex tax laws, potentially saving you time, reducing stress, and ensuring that you take full advantage of tax deductions and credits. They can also represent you before the IRS, providing valuable support in the case of audits or disputes.

If you or someone you know needs tax help, I’ll leave my contact information below. I can connect you with someone who can help you.

Thanks for reading and see you in the next video!

About The Author

Noel Lorenzana is an Illinois-licensed, Registered Certified Public Accountant with over 20 plus years of experience.

Through his online educational content, YouTube videos, easy-to-understand courses and 1-on-1 consulting, he gives you the tools to become tax savvy for yourself. 

Disclaimer: Any accounting, business or tax advice contained in this article, is not intended as a thorough, in-depth analysis of specific issues, nor a substitute for a formal opinion, nor is it sufficient to avoid tax-related penalties.