An article in last week's real estate section on the financial considerations of renting a larger house--while renting to others one's present home--stated that residential property rented after Jan. 1, 1981, could benefit from "accelerated cost recovery system" (ACRS) depreciation. While this is apparent from the language of the 1980 tax law and from IRS publication No. 17, some IRS employes and some tax advisers have stated that ACRS is available only for property acquired (rather than "placed in service") after Jan. 1, 1981. Persons contemplating such transactions should consult their tax advisers.
Rents in the Washington area and the change in the tax laws last year regarding depreciation for homes are making rental houses more attractive in this time of high-interest mortgage loans. For some homeowners, it might make more sense now financially to rent a larger house rather than sell your current home and buy another.
The accelerated cost recovery system introduced in the 1981 tax law allows residential rental property to be depreciated in the earlier years.
Thiry-two percent of the building can be depreciated over the first three years -12 percent the first year, 11 percent the second year and 9 percent the third year.
The deductions by the owner for depreciation on the rental property, as well as for interest on a mortgage loan and for taxes paid, mean that the rental of a residence, as a business transaction under the tax law (Schedule E to Form 1040), will probably result in a loss for income tax purposes, that will be deductible from (or shelter) other taxable income. This increased tax benefit from depreciation on the home being rented out can then be considered as reducing the cost of renting a larger home.
Take a typical example for the Washington area: a couple bought a town house five years ago for $70,000. Interest payments and taxes on it are about $600 a month. That house may have a market value now of about $110,000, if they could sell it.
The couple considers buying a larger 2,500 square-feet, four-bedroom house with some land with a purchase of about $170,000 which would cost about $2,100 a month in interest payments on an 85-percent-of-cost loan at 17 1/2 percent, which they cannot afford. However, they could rent a similar house for about $1,000 a month.
They can rent their town house for about $500 a month and the tax treatment of the rental income would be attractive: the $6,000 in annual payments, $1,000 in real estate taxes and $7,200 in depreciation (12 percent of the cost of the town house without the land, about $60,000).
Thus, there would be a loss of $8,200 on renting their town house in the first year, or almost $700 a month. That would make the effective cost of renting the larger house only about $300 month. This can be compared to theeafter-tax cost of the larger house even if they could afford it: about $2,100 a month in interest and $200 a month in property taxes is deductible. Even if the couple were in the 50 percent tax bracket, the after-tax cost of buying the larger home would be $1,150 a month, compared with $300 for the rental.
Thus, in the present housing environment, with high interest rates, high prices for the purchase of homes, favorable tax treatment of rental property income and relatively low rental prices, renting a larger house and renting out your smaller house makes good financial sense.