Occupying a property is very different from renting it out. The programs that exist as incentives to homeownership usually don't apply to rental property, making the two financing markets very different from each other. On the other hand, since the tax code treats your rental property similarly to the way that it treats a business, you also get a world of tax write-offs on a rental property that don't apply to owner-occupied houses.
When you buy a residence to live in, your lender typically looks at the value of the house and at your ability to pay the loan back. It can use private mortgage insurance or government-backed programs like Federal Housing Administration or Veterans Administration mortgages to let you buy a house with a low down payment and attractive interest rates. Investment property mortgages usually require sizable down payments and are usually closely tied to your credit. In addition, lenders also frequently look at the ability of the property's income to service the debt.
Owner-occupied residences have two main tax deductions -- the write-off for mortgage interest and the deduction for property taxes. To claim these deductions, you need to itemize deductions on your tax return, and you can lose the right to take them if you have a high income, are subject to the Alternative Minimum Tax or have a very large mortgage. When you have a rental property, all of your "ordinary and necessary expenses" are tax deductible. This includes all of your property tax, all of your mortgage interest and all of your operating expenses, including management. You can also claim a depreciation allowance that further reduces your tax liability.
Both owner-occupied and rental properties are subject to a community's use and zoning restrictions, which can include limitations on noise, how you maintain the property and what kind of business, if any, you can conduct in the property. Rental properties fall subject to additional use restrictions. For the IRS to truly consider it a rental, your ability to stay in the property is usually limited to two weeks or less per year. Many local government agencies also impose additional restrictions and licensing requirements on rentals.
Taxes on Home Sale
When you sell your owner-occupied residence, the IRS gives you a generous tax exclusion. Your first $250,000 of profit, or $500,000 if you are married and file a joint return, is completely tax-free provided you lived in the house as your primary residence for at least two of the past five years. Any gain over that amount is taxable at your capital gains tax rate.
Taxes on Rental Sale
All of your profit is taxable as a capital gain when you sell a rental property. In addition, if you sell it for more than your depreciated value, you will also have to pay depreciation recapture tax on the difference between what you originally paid for the property and its improvements and the depreciated value. However, if you use the proceeds of the sale of your rental to buy more rental property, you can structure the transaction as a tax-deferred exchange, carry your basis forward and defer all of your taxes. You can't do this with an owner-occupied residence.
- Bankrate.com: 5 Tips for Financing Investment Property
- Bankrate.com: An Exception to Passive Activity Loss Rules
- IRS: Schedule A (Form 1040)
- IRS: Schedule E (Form 1040)
- AICPA Tax Adviser: Reporting Dilemma: Personal Use of Rental Properties
- Nolo: The $250,000/$500,000 Home Sale Tax Exclusion
- RealEstate.com: Avoiding Capital Gains Tax While Renting Out Your House
- Internal Revenue Service. "Tips on Rental Real Estate Income, Deductions and Recordkeeping." Accessed Sept. 30, 2019.
- Internal Revenue Service. "Publication 946, How to Depreciate Property." Accessed Sept. 30, 2019.
- Internal Revenue Service. "Publication 551, Basis of Assets." Accessed March 16, 2020.
- Internal Revenue Service. "Publication 527, Residential Rental Property." Accessed March 16, 2020.
Steve Lander has been a writer since 1996, with experience in the fields of financial services, real estate and technology. His work has appeared in trade publications such as the "Minnesota Real Estate Journal" and "Minnesota Multi-Housing Association Advocate." Lander holds a Bachelor of Arts in political science from Columbia University.