Converting a rental into a primary residence is not a function built into TOTAL, but can be modeled thanks to TOTAL's flexible plan data. The steps include "selling" the rental at the time of conversion to stop the income, expenses and taxes associated with the rental property, making adjustments to the tax reports to offset any taxable gain from the "sale", and lastly "purchasing" a residence which offsets the cash flow proceeds from "sale" and adds the residence to the clients net-worth.
Converting a rental into a primary residence:
Step 1: “Sell” rental at time of conversion to primary residence.
- Showing the rental as sold will stop the associated rental income, expenses and taxes.
- Adjustments will need to be made to offset taxes due on “sale”.
Step 2: “Purchase” a residence.
- This allows the home value to be included on the yearly net-worth report and handle any remaining mortgage on the property.
- The cost of "purchase" offset the proceeds from the rental "sale".
Example Rental Conversion Case in Golden Years:
Clients plan to sell their current residence in 5 years, moving into a rental property they own. They will pay off the residence mortgage proceeds from the sale and the remaining gain will be invested. The mortgage on the rental property they are converting into their primary residence will be unchanged.
Selling the residence in 5 years is simple. Enter Ind. 1's age of sale in the residence asset data.
The mortgage is paid off with the sale automatically when the mortgage is tied to the residence being sold.
Any remaining proceeds after the mortgage payoff (and potential taxes) will be available for reinvestment.
Converting Rental to Primary Residence:
Modeling the conversion of a rental to a residence takes some time and manual adjustments. Start by running the reports with the rental property entered. Go to the rental property summary report (in this case the rental is "Property 1" making the report of reference Property 1 Summary - G1a in Golden Years).
- Mortgage value as a percentage of property value the year of conversion.
- Number of years remaining on mortgage.
To keep the numbers clear for this example the information included in the reports are for the rental conversion only.
For this example, the conversion is occurring in 5 years, at Ind. 1’s age 55. At the time of conversion, the market value of the rental is $441,632 and the mortgage balance is $158,839.
- Mortgage value as a percentage of property value is 35.97%.
- There are 19 years remaining on the mortgage at the clients age 55.
With these values in hand, move to step 1 of the conversion which is to "sell" the rental, stopping the income, expenses and taxes associated with renting the property.
Step 1: “Sell” rental at time of conversion to residence.
- Enter the sale of the rental property, by providing the age at sale, in this example Ind. 1’s age 55. This stops the associated rental income, expenses and taxes.
- With the sale entered, run the reports to get the values needed to make adjustments to offset the taxes due on “sale”.
- Go to the Income & Tax Analysis for the rental property (Property 1 Income - G1b in this case). The capital gain on sale (column 9) and the unrecaptured section 1250 gain (column 10) need to be manually offset.
- The capital gain from sale flows to Taxable Income Analysis (report D7 in Golden Years) as capital gains. To offset the capital gain, go to the Tax Details tab within the tax section of the Plan Data and select “Schedule D Capital Gains / (Loss). In the future changes table, enter Ind. 1’s age of “sale” and the amount of capital gain generated from the “sale” as a negative amount in the tax report column. In this example, the entry is age 55 with an amount of ($191,632). Enter the client’s age the following year with an amount of 0 to indicate it is a single year adjustment.
- The section 1250 unrecaptured gain from sale flows to the Taxable Income Analysis (report D7 in Golden Years) as other taxable income. To offset the unrecaptured gain, go to the Tax Details tab within the tax section of the Plan Data and select “Other Taxable Income / (Loss). In the future changes table, enter Ind. 1’s age of “sale” and the amount of unrecaptured gain generated from the “sale” as a negative amount in the tax report column. In this example, the entry is age 55 with an amount of ($83,636). Enter the client’s age the following year with an amount of 0 to indicate it is a single year adjustment.
The tax report entries will flow to the Taxable Income Analysis, offsetting the capital gain and unrecaptured gain.
Taxable Income Analysis before tax offsets:
Taxable Income Analysis after tax offsets:
Step 2: “Purchase” a residence at time of conversion.
- In this example, the "purchase" information could be entered using the current residence asset replacement information since the current residence is sold at the same age as the rental is converted the client's residence.
- Alternatively, a new residence asset can be added with a current market value of 0 and same appreciation rate as on the rental, entering the age at sale and residence replacement information, as shown in the images below. The replacement home value will equal the current value of the rental property. Use the mortgage value and number of years for the mortgage determined before the sale was entered and the interest rate on the loan.
Reviewing the Results:
With the tax impact offset, the net results of "selling" the rental property and "purchasing" the residence will be a wash.
For the example case, the proceeds from the rental property "sale" amounts to an income of $282,793, and the down payment resulting from the "purchase" amounts to an expense of $282,777.
Rental property "sale" income:
- Market value $441,632 less mortgage of $158,839 = $282,793
Residence "purchase" expense:
- Net proceeds amount to the down payment cost = ($282,777)
- The "new" mortgage can also be seen on the residence sale worksheet (report B21 in Golden Years), equaling the mortgage remaining on the converted rental property.
Reviewing the Net Worth (report F6 in Golden Years) shows a steadily appreciating real estate market value and declining mortgage balance according to schedule.