Taxes When You Convert Your Rental Property to Your Personal Residence

If you own a rental unit that has a substantial amount of equity, you might consider moving into it before you sell it. Doing so can save you substantial capital gains taxes on your profit. However, there are many tax consequences you should be aware of before you convert a rental unit into your personal residence.

Living in Your Rental Might Help You Save on Taxes

Perhaps the greatest boon in the tax law for property owners is the $250,000/$500,000 home sale exclusion. This rule permits single homeowners to exclude from their taxable income up to $250,000 in profit realized from the sale of a personal residence. The exclusion is $500,000 for married couples filing jointly. There is no limitation on how many times the exclusion may be used during your lifetime.

To qualify for the home sale exclusion, you must own and occupy the home as your principal residence for at least two years before you sell it. Your two years of ownership and use can occur anytime during the five years before you sell—and you don't have to be living in the home when you sell it.

However, the law limits the $250,000/$500,000 exclusion for homeowners who initially use their home for purposes other than their principal residence, such as a rental or vacation home. The rule requires you to reduce pro rata the amount of profit you exclude from your income based on the number of years after 2008 you used the home as a rental, vacation home, or other "nonqualifying use."

A nonqualified use can occur only before the home was used as the taxpayer's principal residence. Rental or other uses of the home after it was used as the principal residence don't constitute a nonqualified use and won't reduce the exclusion.

Recapture of Depreciation Deductions

Converting a rental into your residence won't eliminate all taxes when you sell it. While the home was a rental, you should have claimed a depreciation deduction for it each year. The total amount of depreciation you claimed during the rental period isn't eligible for the exclusion. Instead, you must "recapture" all your depreciation deductions.

In other words, you must report your depreciation deductions on IRS Schedule D and pay a flat 25% tax on these deductions. This can have a significant tax impact. In the example above, Molly would have to pay a deprecation recapture tax of $2,500 (25% x $10,000 = $2,500) for the depreciation deductions she took during the time she rented out the home.

Ownership Taxes and Deductions

Once you occupy the home as your personal residence, you will no longer be able to take any of the deductions you took when the property was a rental. This means you won't get any depreciation deduction and you can't deduct the cost of repairs. However, you will be entitled to the deductions provided to homeowners—that is, you may deduct a personal itemized deduction on IRS Schedule A the amount of your mortgage interest, mortgage insurance premiums, and even property taxes. The expenses must be prorated for the time the home was not considered a rental property.

More Information on Real Estate Tax Issues

See the Nolo article Taxes You Need to Pay When Selling Rental Real Estate for details on relevant tax issues. Also, see IRS Topic 409, Capital Gains and Losses, for more on the subject and links to the relevant IRS publications and forms. For a wide range of tax issues relevant to landlords, see the Nolo book Every Landlord's Tax Deduction Guide.