Converting your home into a rental property can feel like a clever wealth move: keep the low mortgage rate, collect rent, and let someone else help pay down your loan.
But from the IRS’s point of view, you didn’t just become a landlord — you changed how that property is treated for tax purposes. And that shift comes with rules you really don’t want to learn the hard way.
In this guide, we’ll walk through the key tax implications of turning your primary residence into a rental, in plain English, using a simple story and some practical planning tips.
When Your Home Becomes a Rental, the IRS Changes the Rules
Imagine Dana. She bought her home for $300,000, lived there for several years, and now wants to move to a bigger place. Instead of selling, she’s thinking, “Why not rent it out?”
The moment Dana converts her home to a rental, the IRS now treats that property as an income-producing asset, not a personal residence. That means:
- She must report all rental income on her tax return.
- She can deduct rental expenses such as:
- Repairs and maintenance
- Homeowner’s insurance
- Property taxes
- Mortgage interest
- Property management fees
- Utilities she pays for tenants
- All of this is reported on a separate form (typically Schedule E) attached to her federal income tax return.
So far, so good. But the biggest tax shifts show up in two areas:
- Depreciation of the property, and
- The potential loss of the home sale gain exclusion.
Let’s unpack both.
Depreciation: A Powerful Deduction With Very Specific Rules
One of the biggest tax benefits of rental property is depreciation. This is the IRS’s way of recognizing that buildings wear out over time, so they let you deduct the cost over a set period.
For residential rentals, the IRS generally requires you to depreciate the building (not the land) over 27.5 years using straight-line depreciation.
But here’s the key twist for home-to-rental conversions:
Your depreciation basis is the lesser of:
- The property’s fair market value (FMV) on the date you convert it to a rental, or
- Your adjusted basis on that date.
What do those terms mean?
- Fair Market Value (FMV): What a willing buyer would pay a willing seller for the property at the time you convert it to a rental (not what you wish it was worth).
- Adjusted Basis:
- Your original purchase price
- Closing costs that should be capitalized
- The cost of major improvements (new roof, addition, major remodel)
− Any prior depreciation or casualty losses claimed
Because the IRS cares about being able to prove FMV, it’s strongly recommended that you get a professional appraisal at the time of conversion. That way, if you’re ever audited, you have solid documentation for the FMV used in your depreciation calculations.
A quick example with Dana
- Original cost (including certain closing costs): $300,000
- Improvements over the years: $40,000
- Adjusted basis: $340,000
- FMV at conversion based on appraisal: $320,000
For depreciation, Dana uses the lesser of $340,000 and $320,000 → $320,000 as the basis (building portion only, excluding land).
That $320,000 (less the land value) is then depreciated over 27.5 years, creating a nice annual deduction against her rental income.
The Big Trade-Off: The Home Sale Exclusion You Might Be Giving Up
Here’s where many homeowners accidentally step on a tax landmine.
Under Internal Revenue Code Section 121, homeowners can generally exclude up to:
- $250,000 of gain if single, or
- $500,000 if married filing jointly
from the sale of their primary residence, as long as they:
- Owned and lived in the home for at least 2 years out of the 5 years before the sale, and
- Haven’t used the exclusion on another home in the last 2 years.
That’s a huge benefit. But when you convert your home into a rental, you risk losing it.
The 3-year clock after conversion
If you’ve met the 2-out-of-5-year ownership and use test before you move out, you typically have up to 3 years after moving out to sell the property and still qualify for the exclusion.
If you hold it as a rental longer than that, you may no longer meet the 2-out-of-5-year test, and that $250,000 / $500,000 exclusion can disappear for that property.
Back to Dana:
- She lived in the home 4 years before moving out.
- She converts it to a rental and keeps it for 5 more years.
- By the time she sells, it’s been 9 years since she bought it and more than 5 years since she lived there.
Result: she no longer qualifies for the Sec. 121 exclusion. Every dollar of gain (above her adjusted basis) is now potentially taxable — plus depreciation recapture on what she deducted while it was a rental.
In contrast, if she had sold the home within 3 years of moving out, she might have been able to exclude up to $250,000 / $500,000 of gain and walk away with that profit completely tax-free.
This is why timing is everything with home-to-rental conversions.
Reporting Rental Income and Expenses Correctly
Once your former home is officially a rental, you’ll typically report:
- Rental income
- Allowable expenses (repairs, insurance, property taxes, mortgage interest, HOA dues, etc.)
- Depreciation
…on Schedule E: Supplemental Income and Loss, attached to your Form 1040.
A few practical notes:
- Repairs vs. improvements
- Repairs (fixing a broken window, patching drywall, servicing the furnace) are generally deductible in the year paid.
- Improvements (new roof, new HVAC, major remodel) are typically added to basis and depreciated.
- Keep great records – invoices, receipts, mileage logs, appraisal report, and a clear date the property was “placed in service” (made available for rent).
These details matter when you (or your CPA) prepare your return — and even more if the IRS has questions later.
What Happens When You Eventually Sell the Rental?
Here’s another twist people don’t always see coming:
When you sell the rental property later, the basis used to calculate gain or loss depends on whether the sale produces a gain or a loss.
- If the sale results in a loss, the IRS uses the FMV at the date of conversion (minus land, plus later improvements) as the starting point for loss calculations.
- If the sale results in a gain, the IRS uses your adjusted basis (original cost + improvements − depreciation taken) at the time of sale.
This split-basis rule is designed to prevent you from turning a decline in value that happened while it was your personal residence into a deductible rental loss.
On top of that, any depreciation you took while it was a rental is generally subject to depreciation recapture, taxed at rates up to 25%, separate from your regular capital gain.
Translation: the decisions you make at the conversion stage — including getting an appraisal and tracking your basis properly — directly affect how much tax you’ll pay when you eventually sell.
Practical Planning Tips Before You Convert Your Home to a Rental
If you’re weighing “sell vs. rent,” here are some big-picture planning questions to consider before you put up a “For Rent” sign:
1. How big is your potential gain today?
- If selling now would generate a large gain, the home sale exclusion might be worth more than future rental income.
2. Will you likely sell within 3 years of moving out?
- If yes, you may be able to enjoy some rental deductions and still capture the exclusion later.
- If no, you may be trading a large tax-free gain for a long-term rental play.
3. Do you understand your basis numbers?
- Nail down your original cost, improvements, and current FMV at conversion.
- Get a professional appraisal at the time of conversion to document FMV.
4. Are you ready for the record-keeping?
- Rentals require solid bookkeeping: income, expenses, mileage, repairs vs. improvements, and depreciation schedules.
5. Have you talked with a tax professional before making the switch?
- The optimal strategy can depend on your income level, other investments, and long-term plans — things software and generic advice don’t fully capture.
Thinking About a Home-to-Rental Conversion? We Can Help You Run the Numbers.
Turning your home into a rental can absolutely be part of a smart wealth-building strategy — if you coordinate the move with the tax rules instead of fighting them.
At JS Morlu, we help homeowners, investors, and high-income families:
- Evaluate sell vs. rent from a tax and cash-flow perspective
- Calculate basis and depreciation correctly
- Plan around the $250,000 / $500,000 home sale exclusion window
- Structure long-term rental strategies as part of a broader tax plan
If you’re considering converting your home to a rental, talk to us before you make the move. A one-hour planning session today can save you from a very expensive surprise later.
Ready to explore your options?
Contact JS Morlu to schedule a consultation and map out a tax-efficient strategy for your home-to-rental conversion.