How to Report Conversion of Rental Property to Personal Use

Converting a rental property to personal use involves significant tax implications that must be carefully addressed. This transition can affect deductions, depreciation, and potential capital gains, all of which need to be accurately reflected in tax filings.

Deductions After Conversion

When a rental property becomes a personal residence, the tax deductions available to the owner change. While rental property owners can deduct expenses like mortgage interest, property taxes, and operating costs against rental income, these deductions are more limited for personal residences.

Mortgage interest remains deductible but only on mortgage debt up to $750,000 for joint filers under the Tax Cuts and Jobs Act. Property taxes are deductible but are capped at $10,000 for state and local taxes, including income and sales taxes. This cap often limits the tax benefits previously available during the rental period.

Expenses like repairs or maintenance, which were deductible as rental expenses, are no longer eligible after the property is converted to personal use. It is essential to review expenses during the transition to ensure compliance with IRS rules, as expenses unrelated to rental activity cannot be deducted.

Depreciation Recapture

One of the key tax considerations in converting a rental property to personal use is depreciation recapture. During the rental period, property owners can deduct depreciation to account for wear and tear. However, upon selling the property, this depreciation must be recaptured and taxed, typically at a rate of 25%. For instance, if $50,000 in depreciation was claimed, the same amount would be subject to recapture, potentially resulting in a substantial tax obligation.

Depreciation recapture also impacts the property’s adjusted basis, which is critical when calculating capital gains. The adjusted basis is determined by subtracting accumulated depreciation from the original cost of the property. This figure directly affects the gain or loss upon sale.

Basis Adjustments for Personal Use

When a rental property transitions to personal use, adjustments to the property’s basis are necessary for future tax considerations. The original basis includes the purchase price and associated costs like legal fees and title insurance. Improvements made during the rental period, such as a new roof or major remodeling, increase the basis and should be well-documented.

At the same time, depreciation claimed during the rental phase reduces the basis. Maintaining accurate records of all depreciation claimed is critical for calculating the adjusted basis. The interplay between depreciation and improvements requires careful attention to IRS guidelines to ensure accurate reporting.

Allocation of Mixed Use

When a property serves both personal and rental purposes in the same tax year, expenses and income must be allocated proportionally. The IRS requires property owners to proration expenses based on the percentage of personal versus rental use. For example, if a property is rented for 180 days and used personally for 60 days, 75% of expenses, such as mortgage interest and utilities, can be allocated to rental activities.

Accurate record-keeping is essential to support these allocations and avoid IRS scrutiny. Rental income must also be reported correctly on Schedule E, which includes gross rental income and any payments related to rental activities.

Capital Gains Implications

Capital gains tax treatment is a crucial factor when selling a property converted from rental to personal use. The adjusted basis, sales price, and fair market value (FMV) at the time of conversion influence the tax outcome. While the FMV at conversion does not reset the basis, it helps determine whether a gain or loss is recognized.

If the property appreciates in value, the gain is subject to long-term capital gains tax rates, ranging from 0% to 20% depending on income. The exclusion under IRC Section 121 may apply if the property is used as a personal residence for at least two of the five years preceding the sale. This exclusion allows single filers to exclude up to $250,000 of gain ($500,000 for married couples filing jointly). However, the portion of the gain attributable to depreciation recapture remains taxable.

If the property depreciates in value after conversion, the loss cannot be deducted for tax purposes, as personal-use properties are not eligible for capital loss deductions. Timing and strategic planning are critical when selling a converted property to minimize tax liability, and consulting a tax professional is advisable.

Documentation for Reporting

Proper documentation is essential for accurate tax reporting when converting a rental property to personal use. Taxpayers must maintain detailed records of the property’s use, expenses, and eventual sale to substantiate claims and avoid disputes or penalties.

Maintaining a clear log of the property’s use history, including periods of rental, availability for rent, and personal use, is crucial. Supporting evidence like lease agreements, utility bills, or personal calendars can help verify these details.

Financial records, including purchase documents, receipts for improvements, and depreciation schedules, are equally important. For example, receipts for improvements made during the rental period can support adjustments to the basis, while prior-year depreciation schedules are necessary for calculating depreciation recapture. Comprehensive record-keeping ensures compliance and accurate tax reporting.