When you move into your rental property, it becomes a primary residence, and you must stop claiming depreciation, repairs, and operating expenses immediately. However, the depreciation taken while it was a rental is not reversed; instead, it is "recaptured" and taxed as ordinary income (up to 25%) when you eventually sell the home.
Once you move into your rental property, it stops generating income, meaning you're no longer entitled to claim tax-deductible expenses like maintenance, depreciation, or loan interest. A qualified tax agent can help clarify your eligibility to claim based on your financial situation.
There is nothing in the US Federal tax code that says you have no choice and MUST depreciate your rental property. Most rental property owners do, because they recognize that they get a very generous tax break up-front by taking depreciation as early as possible.
One of the most popular ways to defer depreciation recapture is to complete a 1031 exchange, also known as a “like-kind exchange”.
Under the updated rules, you can issue a notice to evict your tenant so you or a close family member can move into the property. However, certain conditions must be met: The tenancy must have lasted for at least 12 months before you issue notice.
If you move back into a home you once rented out, then sell it, you can only exclude the profit from the time it was your main residence. Any gain tied to rental periods after 2008 is taxable. Also, if you claimed depreciation while renting, that part is always taxable – you can't exclude it.
If the asset's sale results in a capital gain, it triggers a depreciation recapture tax liability. If the asset is sold at a loss, depreciation recapture will not apply. There is a capital gain if the taxpayer sells the asset for more than the adjusted basis.
One of the downsides of rental property depreciation is the recapture tax. When you sell a depreciated property, you may be subject to a recapture tax on the depreciation deductions you previously claimed. This tax can be substantial and should be factored into your long-term investment strategy.
You simply stop depreciating once you've reached the end of the recovery period: Residential rental: after 27.5 years. Commercial rental: after 39 years.
Misclassification, incorrect recovery periods, and improper use of Section 179/bonus depreciation are common errors. Proper documentation and adherence to IRS guidance and industry-specific matrices are essential to avoid audit issues.
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.
Converting a rental property into a primary residence is a significant financial move with potential tax implications that necessitate careful planning. By leveraging tools like Section 121 of the IRS code and 1031 exchanges, homeowners can navigate the complexities of this process.
Tenant Issues and Vacancies
Tenants can sometimes fail to pay rent on time, damage property, or violate lease agreements. Even reliable tenants eventually move out, leading to vacancies. Each empty month means lost income, and finding new tenants often requires marketing, screening, and additional costs.
The "6-year rule" for investment property, primarily an Australian tax concept (ATO), lets you rent out your former main home for up to six years while still potentially claiming the main residence exemption (CGT-free) on it, provided you lived there first, don't claim another property as your main residence for that period, and either move back in or sell within the timeframe. The clock resets if you move back in for a significant time (e.g., 6+ months) and then rent it out again, but you can only have one main residence exemption at a time.
Investment property: Must be occupied by the owner for less than 14 days of the year.
Want to lower the tax bill on the sale of your home? There are ways to reduce what you owe or avoid taxes on the sale of your property. If you own and have lived in your home for two of the last five years, you can exclude up to $250,000 ($500,000 for married people filing jointly) of the gain from taxes.