Turning a Personal Residence Into Rental Property

There are many reasons to turn a personal residence into a rental property. You could be in a situation where you can't sell a house that no longer serves your needs. Alternately, you might have tired of going to a vacation property. Regardless of the reason, the first step in converting your home to your rental property is to stop living in it and start renting it out.

The Internal Revenue Service has multiple categories that define how a rental house gets treated. If you still live in the house at least part-time, but rent it out for 14 or fewer days per year, the IRS considers it to be a personal residence and your rental income doesn't need to be reported. A house that you never live in is considered a pure investment. Houses that fall in between require you to allocate costs between your personal and investment use, so if you use the house 10 percent of the time, you can only write off 90 percent of its expenses as a rental expense.

When your house turns into a rental property, you stop writing off its mortgage interest and property taxes on your Schedule A. Instead, you report all of its rental income and all of its rental expenses on Schedule E. Furthermore, the IRS allows you to write off all of the expenses that you incur in owning it and renting it out. You can even claim a portion of its value every year as a depreciation deduction as a way of compensating you for the building's gradual aging and deterioration. The one limitation to this process occurs if you also have personal use of the house. Then, you'd need to allocate the costs between rental and personal use on a pro-rata basis.

The IRS may even let you write off any losses that you experience in owning and managing your rental property against your earned income. To qualify for this, you can only use the residence personally for both fewer than 14 days per year and fewer than 10 percent of the total days that it could be available for rent. If you meet this standard and your Adjusted Gross Income is $100,000 or less, you can write off up to $25,000 in losses from your rental property as a deduction from your income every year. Your maximum write-off goes down by $1 for every $2 of income above the threshold, so if your AGI is above $150,000, you won't be able to claim it.

When you sell the property, you may still be able to claim at least a portion of the $250,000 or $500,000, if you are married, home sale capital gain exclusion. Since the IRS requires you to live in the house for two of five years, if it's been a rental for fewer than three years and you lived in it prior to converting it, you can avoid paying capital gains on profits although your depreciation will be taxed. Another option is to use the proceeds from the sale of the property to buy more investment property. If you do this and structure the transaction as a tax-deferred exchange, you can defer paying all of your capital gains and depreciation recapture taxes.