The 3-in-5 window
Section 121 requires 2 of the last 5 years as a primary residence. Once you rent the home for 3+ consecutive years, you lose the exclusion. Selling within the window protects the exclusion on the personal portion. This is the single decision that most changes the tax outcome: a sale at year two of renting can shelter hundreds of thousands of gain that a sale at year four cannot.
Depreciation starts immediately
The moment the home goes on the rental market, you depreciate 27.5-year straight-line on the building value (land isn't depreciable). Depreciation taken (or allowable) must be recaptured at up to 25% on eventual sale. The word 'allowable' has teeth: skipping depreciation doesn't skip the recapture, so failing to claim it is pure loss. If prior years were filed without it, a correction can catch the deductions up.
What becomes deductible
Everything that keeps a rental running now offsets the rent: repairs, insurance, property management, HOA dues, utilities you cover, mortgage interest, property taxes, travel to the property for management. Improvements are capitalized and depreciated rather than deducted, and the repair-versus-improvement line is one of the most litigated in landlord taxation; invoices worded clearly help.
Passive loss limits
Rentals commonly show paper losses (thanks to depreciation) while cash flowing. Up to $25,000 of rental loss can offset ordinary income for active participants, phasing out between $100,000 and $150,000 of MAGI. Above that, losses aren't lost; they suspend and carry forward, releasing against future rental income or when the property sells. Snowbird-priced South Florida homes convert into rentals with big depreciation bases, so these limits come up constantly.
The 1031 alternative
Once the home has genuinely become investment property, a 1031 exchange can roll the entire gain, exclusion-eligible or not, into another investment property with tax deferred. Combining strategies is possible with care: sell within the 121 window for the exclusion, or hold and exchange later, but the middle path of missing both is the one to plan away from.
Common questions
- What's the basis for depreciation?
- Lower of your adjusted basis or FMV on the date of conversion.
- Can I move back in and restore the full exclusion?
- Partially. Re-occupying restores 2-of-5 eligibility, but gain attributable to the rental years after 2008 is prorated out of the exclusion, and depreciation recapture applies regardless. The clean exit is earlier, not later.
- Do I need a formal appraisal at conversion?
- Not strictly required, but contemporaneous evidence of value (an appraisal or solid comparable sales) protects the depreciation basis if the IRS asks years later. It's cheap insurance.
- What if I rent it below market to family?
- Below-market rental to relatives can reclassify the property as personal use, disallowing losses and most deductions. Charge market rent and document it if you want rental treatment.
Related
Personal Income Tax Preparation
Federal and state 1040 preparation with year-round planning. We handle W-2, 1099, K-1, rental, and crypto income for individuals in Florida and all 50 states.
Tax Planning
Year-round tax planning for individuals and business owners. We project the year's income quarterly and model decisions before they become tax liabilities.
Taxes After Selling a Home
Section 121 excludes up to $250K single / $500K MFJ of gain on your primary home. The 2-of-5-year ownership and use tests, partial exclusions, and recapture.
Related tax topics
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The taxability of a settlement depends on what it compensates: physical injury is usually tax-free; punitive damages, interest, and lost wages are taxable.
Taxes in Your First Year of Business
Entity choice, accounting method, quarterly estimates, startup cost deductions, and retirement plans: the first-year decisions that set your tax structure.
Tax Changes When You Get Married
Marriage changes filing status, withholding, and brackets. When Married Filing Jointly beats Separately, new W-4s for both spouses, and the marriage penalty.
Tax Changes After Divorce
Filing status, Child Tax Credit assignment via Form 8332, and QDRO retirement splits after divorce. Post-2018 alimony is neither deductible nor taxable.