How Long Do You Have to Live in a House Before Renting It Out?

Converting a primary residence into a rental property involves financial and legal considerations. Homeowners must understand tax regulations and mortgage agreement clauses that govern such transitions. These factors impact how long a homeowner needs to reside in a property before renting it out, and they influence ongoing financial obligations and benefits. Careful planning ensures compliance and helps optimize financial outcomes.

Qualifying for the Primary Residence Capital Gains Exclusion

Selling a home can involve a capital gain, and Internal Revenue Code (IRC) Section 121 offers an exclusion for gains from the sale of a principal residence. Single taxpayers can exclude up to $250,000 of gain, and married couples filing jointly can exclude up to $500,000. To qualify, homeowners must satisfy both an “ownership test” and a “use test.”

The ownership test requires the taxpayer to have owned the home for at least two years during the five-year period ending on the date of sale. The use test mandates the home must have been the taxpayer’s principal residence for at least two years within the same five-year period. These two-year periods do not need to be continuous. For married couples filing jointly, only one spouse needs to meet the ownership test, but both must satisfy the use test.

A partial exclusion of gain may be available if the full ownership and use tests are not met. This applies when the sale occurs due to a change in employment, health reasons, or unforeseen circumstances. For example, a change in employment may qualify if the new job is at least 50 miles farther from the home than the previous one. Health reasons include sales primarily for medical diagnosis, treatment, or care.

Unforeseen circumstances, as defined by IRS regulations, include events a taxpayer could not reasonably have anticipated before occupying the residence. These can include involuntary conversions, natural disasters, or specific life events like death, unemployment, or divorce.

When determining if a partial exclusion applies, the IRS considers if the event was the primary reason for the sale and occurred while the taxpayer owned and used the property as a principal residence. The partial exclusion is calculated proportionally based on the portion of the two-year period met. For instance, if a taxpayer qualifies after living in the home for one year, they may exclude half of the maximum allowable gain. This exclusion applies once every two years and only to a principal residence.

Understanding Mortgage Occupancy Clauses

Most mortgage agreements for owner-occupied properties contain an occupancy clause, requiring the borrower to reside in the home as their primary residence for a specified period. This clause is standard for loans offering favorable terms, like lower interest rates or reduced down payments, as owner-occupied properties are considered less risky by lenders. The typical duration ranges from six months to a year after the loan closing date.

Lenders include an occupancy clause primarily to mitigate risk and prevent mortgage fraud. Loans for primary residences have more attractive conditions than those for investment properties, as homeowners are more likely to maintain a property they live in and are less prone to default. This clause ensures borrowers genuinely use the property as their home, not immediately converting it to a rental without lender approval.

Violating an occupancy clause can lead to consequences for the borrower. Lenders may consider it mortgage fraud, resulting in penalties, fees, or an increased interest rate. In severe cases, the lender can “call the loan due,” demanding immediate repayment of the outstanding balance. If the borrower cannot repay, it could initiate foreclosure, and future financing may become challenging. Homeowners considering renting should contact their mortgage lender to discuss intentions and options, such as refinancing, to avoid breaching their loan agreement.

Tax Implications of Converting to Rental Property

Converting a primary residence to a rental property introduces tax considerations centered on income and expenses. Once designated for rental use, the property becomes subject to rules governing rental income and deductible expenses, including depreciation. Accurate record-keeping of all income and expenditures is essential for tax reporting.

Depreciation is a tax deduction for rental property owners, allowing them to recover the cost of the property over its useful life. This deduction accounts for the wear and tear a property experiences over time. To calculate depreciation, the owner determines the depreciable basis, which is generally the cost basis minus the value of the land. Land is not depreciable. Residential rental properties are depreciated using the straight-line method over 27.5 years under the Modified Accelerated Cost Recovery System (MACRS) General Depreciation System (GDS).

When a rental property is sold, “depreciation recapture” applies. This refers to the portion of any gain on the sale attributable to previously claimed depreciation deductions. This amount is taxed at a maximum rate of 25% at the time of sale. Any remaining gain beyond the recaptured depreciation is subject to standard capital gains tax rates.

Rental income includes all amounts received for the use of the property, such as rent payments, non-refundable fees, and payments from a tenant to cancel a lease. Owners can deduct ordinary and necessary expenses incurred in managing and maintaining the rental property. Common deductible expenses include:

• Mortgage interest
• Property taxes
• Insurance premiums
• Utilities
• Repairs (but not improvements)
• Advertising
• Property management fees
• Legal or professional fees

Most individual landlords report their rental income and expenses on Schedule E (Form 1040).