Key insights
- Start tax planning before converting your home to a rental to help support depreciation deductions and future gain or loss calculations.
- Understand how rental use changes your tax treatment, including impacts on depreciation, deductible expenses, passive activity loss rules, and the net investment income tax.
- Consider your exit strategy from the beginning — the rental period length, depreciation recapture, and sale timing may affect your eligibility for the home sale exclusion and your eventual taxable gain.
Before turning your home into a rental, weigh the tax impacts.
Many property owners think tax planning starts after a tenant moves in, but some of the most important tax decisions are made before listing your home for rent.
Converting your home into a rental property can create rental income, preserve future appreciation potential, and provide access to deductions not available while the home was used personally. The long-term tax result depends on how you address tax basis, depreciation, loss limitations, home sale exclusion, and eventual sale planning at the outset.
Establish your tax basis before converting your home to a rental
Before renting your home, document both the property's adjusted tax basis and its fair market value on the conversion date.
Adjusted basis generally includes the original purchase price, certain acquisition costs, and capital improvements made during ownership. A professional appraisal can help establish fair market value and provide support if the valuation is later reviewed and/or challenged.
These records matter because the value used to calculate depreciation may differ from the value used to determine gain or loss when the property is sold. Various adjustments, including depreciation deduction and certain basis allocations, can cause the property’s adjusted basis for gain/loss to differ from its depreciable basis. Inadequate documentation can create problems years later when depreciation schedules need to be rebuilt or sale or depreciation calculations need support.
What expenses can you deduct for rental properties?
For a former residence converted into long-term rental property, expenses incurred before conversion are generally personal expenses. Once placed into service as a rental property, rental income and expenses are generally reported on Schedule E. Identify which costs relate to the rental activity and keep records supporting both the amount and the timing of each deduction.
Deductible expenses generally include costs to operate, maintain, and manage the property, along with depreciation. Mortgage interest may also shift from personal-use treatment to an expense connected with an income-producing activity.
Property owners should also separate repairs from improvements. Repairs may be currently deductible, while improvements are generally capitalized and recovered over time.
How rental property depreciation works
Depreciation is often one of the most valuable tax benefits available to residential rental property owners. Step one is determining the correct depreciable basis.
When a personal residence is converted to long-term rental use, the depreciable basis is generally the lesser of:
- The property's adjusted basis on the conversion date
- The property's fair market value on the conversion date
Property owners must also allocate value between land and the building, as land isn’t depreciable. The method used mut be reasonable and supportable.
Residential long-term rental property is generally depreciated over 27.5 years using the straight-line method under the Modified Accelerated Cost Recovery System (MACRS). Depreciation begins when the property is placed in service, meaning it’s ready and available for rent, even if a tenant isn’t secured.
Could a cost segregation study save taxes?
You may not necessarily have to depreciate the entire long-term residential rental property over 27.5 years. In certain circumstances, a cost segregation study may identify building components or land improvements qualifying for shorter recovery periods, allowing some depreciation deductions to be recognized earlier.
Accelerating depreciation may improve near-term cash flow and after-tax returns. The analysis is most relevant for properties with substantial basis or meaningful improvement costs.
As with any depreciation strategy, the potential benefits should be weighed alongside future depreciation recapture considerations and state tax treatment.
Can you claim the home sale exclusion after converting your home to a rental?
In many markets, preserving eligibility for the home sale exclusion may be more valuable than several years of rental tax deductions.
Under Internal Revenue Code §121, eligible taxpayers may exclude up to $250,000 of gain ($500,000 for certain married couples filing jointly) from the sale of a principal residence if ownership and use requirements are satisfied.
Generally, you must have owned and used the property as a principal residence for at least two of the five years preceding the sale.
This creates an important planning opportunity. A homeowner who converts a residence into a rental property may still qualify for all or a portion of the exclusion if the ownership and use requirements are satisfied at the time of sale.
Two rules deserve particular attention.
Nonqualified use
Rental periods after the home stops being used as a principal residence may reduce the amount of gain eligible for exclusion. As the rental period increases, a larger portion of appreciation may become taxable.
Depreciation recapture
Depreciation receives separate treatment. Gain attributable to depreciation claimed — or that could have been claimed —during the rental period generally can’t be excluded under Section 121 and may be taxed at rates of up to 25%.
A common misconception is failing to claim depreciation avoids recapture. In practice, the tax rules generally apply to depreciation that was allowable, regardless of whether the deduction was claimed.
The timing of a future sale can affect how much gain remains eligible for exclusion. That timing should be part of the conversion discussion, rather than a year-of-sale decision.
Rental property loss limitations and passive activity rules
Rental real estate is generally classified as a passive activity, which can limit your ability to use rental losses against wages, business income, or investment income.
Taxpayers who actively participate in management activities may qualify for a special allowance permitting up to $25,000 of rental real estate losses to offset non-passive income. The benefit begins to phase out when modified adjusted gross income exceeds $100,000 and is fully phased out at $150,000.
Losses that can’t currently be deducted are generally suspended and carried forward. They may become available to offset future passive income or gain recognized upon a taxable disposition of the property.
The real estate professional rules can create additional planning opportunities for taxpayers with significant involvement in qualifying real estate activities. Qualification depends on detailed participation records and careful application of the rules.
How the Net Investment Income Tax applies to rental income
Higher-income taxpayers should also evaluate the potential impact of the 3.8% Net Investment Income Tax (NIIT). The NIIT can increase the effective tax rate on rental income and certain gains, making it an important consideration when evaluating long-term after-tax returns.
Coordinate federal and state tax consequences
State tax treatment doesn’t always follow federal rules, and those differences can materially affect after-tax results.
Property owners should evaluate both federal and state consequences before converting the property rather than assuming federal treatment will produce the same state result.
How CLA can help with tax planning for rental properties
Converting a former residence into a rental property can be an effective wealth-building strategy, but the tax outcome depends on more than reporting rental income and claiming annual deductions. Holding period and exit strategy should guide decisions made at conversion, including basis documentation, depreciation choices, loss utilization, home sale exclusion planning, and sale timing.
Owners who address these issues before the property is placed in service are better positioned to preserve deductions, manage taxable gain, and make informed decisions for whatever might be next. CLA’s real estate tax team can help you evaluate the tax implications of your rental property — from conversion through eventual sale.