I remember when we first tried to sell our old home over a decade ago.

It was a period of immense change in the household. Our youngest was graduating and going off to college, and our oldest was graduating from college and going to graduate school. My husband was retiring early from the place where he had worked for 21 years to start a new career in a new location, and I was going along for the ride.

When setting the house up for sale in the spring of 2008, we did everything the house stager suggested, including painting inside and out.

It didn’t take too long before we got a decent offer. Sadly, it fell through. Apparently they found a cheaper home in the adjacent neighborhood that would work for them. Then we went through a few lowball offers as spring turned to summer.

During this time, we considered purchasing a potential buyer’s small “tree house” home very close to downtown, enabling them to afford our house and giving us either an inexpensive place to stay when we visited or a rental property. In the end, that deal fell apart, too.

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Considering Whether to Rent Out the House

Over the course of the summer, we entertained the idea of renting out the house. Several prospective tenants were apparently downsizing from homes they could no longer afford, as the payments on their variable-rate mortgages jumped. I wouldn’t be surprised if these people were getting leases lined up before abandoning their homes and tanking their credit.

One couple even proposed that we pay them to live in our house so that we could keep it on the market and continue to show it.

In the end, we agreed on an 18-month lease with an expatriate family in hopes that they might buy the house if they ended up staying in the area. This was now October, and the proverbial shit hit the fan in the financial and housing world.

We hoped the rental income would cover our expenses. We paid for property maintenance, covered repairs (flood damage and waterproofing the basement and a cracked toilet — don’t ask), and paid the real estate agent a fee for finding said tenant.

Unexpected (Tax) Costs

Rather than earn passive income from renting out our house, we ended up with an absolutely huge tax bill for 2009 that we were not prepared to pay — as well as penalties for being under-withheld.

So what went wrong? We didn’t understand the tax laws regarding passive income and losses.

Rental income is generally considered to be passive income, and there are limitations to the number of passive losses that you can recognize.

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Crunching the Numbers on Passive Losses

If you “actively” manage the property (own at least 10 percent and make major decisions about rent, tenants, repairs, and improvements) and if your annual modified adjusted gross income (AGI plus tax-exempt interest) is $100,000 or less — whether you’re single or you’re married filing jointly — you could recognize a passive loss of up to $25,000, according to the Internal Revenue Service.

This means that, at the end of the fiscal year, if the amount of money you’ve lost on your property exceeds the amount of money earned by your property (in the form of rent), you can deduct that amount from the taxes you pay on your active income (in other words, your day job).

“Losses from a passive activity can only be deducted against other passive income. However, rental activities are an exception to the general rule,” says certified tax resolution specialist and enrolled agent Jeffrey A. Schneider.

“If you actively participate in the activity of the rental, meaning you are a participant in the operation of the rental, you can deduct up to $25,000 in losses against all other income,” Schneider adds.

However, if your modified adjusted gross income is between $100,000 and $150,000, the amount you can deduct is reduced by one dollar for every two dollars of income.

So if you earned $150,000 from both your job and your rental property, you aren’t allowed to use any passive losses against your earned income.

You can use passive losses only to offset passive income. Remaining losses roll over to future years.

Learn From Our Mistakes

In the end, we sold the house, were able to recognize those losses to offset our earned income, and received a sizeable refund. Before you lease your house, do your tax homework. Do you know what renting out your house will cost you?

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Insurance Implications

There was so much more that we should have researched before leasing the house. Here is what you need to know if you intend to rent out your house.

First of all, your homeowners insurance is likely to double in cost if you aren’t living in your home. Make sure you have enough liability insurance (umbrella policy) to cover your net worth, as well.

Calculating Taxes

Second, estimate your tax situation. Calculate what your income taxes will be and adjust your withholdings accordingly.

All of those property tax and mortgage interest deductions that you used to get will disappear because the house is not your primary residence.

“Keep up-to-date accounting records so you can accurately project your tax due,” recommends certified public accountant Logan D. Howard. “Estimated tax payments should be paid quarterly based on your net income.”

“Start with your rental income and deduct interest, taxes, insurance, repairs, maintenance, and any other expenses related to the property,” Howard adds. “You may want to consider hiring a tax professional who can help you properly.”

Finally, remember that loss recognition applies only to individuals who obtain passive income from their rental properties. If you manage multiple properties, you may be able to file as a real estate professional.

“A taxpayer qualifies as a real estate professional if more than half of the personal services performed are in real property trades or businesses,” Schneider says. “If you qualify, then you can take 100 percent of the losses against your other income. No limitations are applied.”

If this describes your property portfolio, you’ll want to consult a tax professional to make sure you pay your fair share.

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The Bottom Line on Renting Out Your House

Don’t assume, as we did, that it would be a wash when we deducted these expenses from the rental income. Consider your modified adjusted gross income, take into consideration your potential losses, and, if necessary, employ a CPA to assist in your renting endeavors. Happy leasing!

Additional reporting by Connor Beckett McInerney.