Converting your home to a rental: basis, depreciation and Section 121

By Tom, CPA · Updated October 27, 2026

Part of: Rental Property Taxes

TL;DR: When you convert your home to a rental, depreciation is based on the lower of your adjusted basis or the fair market value on the conversion date, and it starts when the property is ready and available for rent. You can still exclude gain under section 121 if you sell within about 3 years of moving out, but depreciation taken after May 6, 1997 is always taxed.

Educational only, not tax, legal, or investment advice. Examples are illustrations, not predictions. Rules and limits change; verify current figures and talk to a qualified professional about your situation.

Every FIRE forum has this thread: "We're moving. Should we sell the house or keep it as a rental?" Half the replies say keep it forever. The other half say sell and buy index funds. Both halves usually forget the tax rules, which are the same either way and quietly decide which answer is better. Your tenant pays the mortgage; the IRS pays for the roof (eventually, over 27.5 years), starting from a basis you need to get right on day one.

CPA Warning Label: The 121 exclusion on a converted home expires about 3 years after you move out. Keeping the rental past that date can turn tax-free gain into taxable gain.

Basis is lower of cost or FMV

Under Treas. Reg. 1.168(i)-4(b) and Publication 527, when personal-use property is converted to rental use, the basis for depreciation is the lower of:

• Your adjusted basis on the conversion date (purchase cost plus improvements, minus casualty losses and the like), or
• The fair market value on the conversion date.

Then you subtract the land. Land isn't depreciable. Use a reasonable allocation: the county assessor's land-to-building ratio, an appraisal, or comparable land sales. See land vs building allocation.

If your home has appreciated, the adjusted basis is usually lower, so you use it. If it has fallen in value, you use the lower FMV. The lower-of rule also applies for figuring a loss on a later sale: you can't deduct the personal-use decline in value that happened while you lived there.

Get documentation on the conversion date: a broker's opinion, an appraisal or a comparative market analysis. It costs little now and saves arguments later.

Start of depreciation

Depreciation begins when the property is placed in service, meaning ready and available for rent, even if no tenant has moved in. Listing it for rent counts. Living in it while you fix it up doesn't.

• Residential rental property uses 27.5-year straight line with the mid-month convention. A unit placed in service in July gets 5.5 months of depreciation in year one.
• Appliances and furniture you leave for tenants are 5-year property, based on the lower of their basis or FMV at conversion. Old appliances often have little value.
• Expenses before the property is available for rent (cleaning, painting to get it ready) are generally capitalized or treated as start-up costs, not deducted as rental expenses, if the property isn't yet in service. Once it's listed, ordinary rental expenses are deductible.

File Form 4562 for the first year. If you forget depreciation, the IRS still reduces your basis by depreciation allowable. Catch-up details: Form 3115.

3-of-5-year 121 window

The home sale exclusion requires that you owned and used the home as your principal residence for at least 2 of the 5 years before the sale. That means after you move out, you have about 3 years to sell and still exclude up to $250,000 of gain ($500,000 married filing jointly).

The rental period after you move out is not nonqualified use under section 121(b)(5)(C)(ii)(I), because it's after your last use as a principal residence. So you don't lose part of the exclusion for those rental years. (The nonqualified use rule bites in the other direction, rental first then home; see moving into your rental.)

After 3 years, the exclusion is gone. The property is just a rental with a basis you need to track. If you still want to defer at that point, the tool is a 1031 exchange, and inside the 3-year window you can combine both (see 1031 and 121 combo).

Recapture on sale

Even inside the 3-year window, depreciation taken (or allowable) after May 6, 1997 isn't excludable under section 121(d)(6). It's taxed as unrecaptured section 1250 gain at up to 25%. The rest of the gain, up to the exclusion amount, is excluded.

Gain for sale purposes uses your regular adjusted basis (cost plus improvements minus depreciation), not the lower-of-FMV depreciation basis. If the house dropped in value while you lived there and you later sell at a loss, the loss is limited using the FMV-at-conversion basis.

Suspended passive losses from the rental years are released on a fully taxable sale. If the gain is fully excluded except depreciation, released losses can offset other income. See suspended passive losses.

The conversion year: splitting expenses

In the year you convert, you have two tax lives for one house. Expenses are split by time:

• Mortgage interest and property tax for the months you lived there go on Schedule A (if you itemize, subject to the mortgage interest and SALT limits). The rental months go on Schedule E, without those limits.
• Insurance, utilities and HOA dues for the personal months are nondeductible; the rental months are rental expenses.
• Repairs made after it's available for rent are deductible rental expenses. Improvements are added to basis and depreciated.
• Prepaid items, such as an annual insurance premium, are allocated by days.

Fran converted on July 1, so roughly half of 2024's interest and taxes went on Schedule A and half on Schedule E. With the standard deduction, the Schedule A half provided no benefit, while the Schedule E half reduced rental income. A small nudge toward converting earlier in the year, if the move timing is flexible.

Security deposits aren't income when received if you plan to return them. Keep them separate. Last month's rent paid in advance is income when received.

Example

Illustration (made-up numbers): Frugal Fran and her spouse bought a house in 2015 for $300,000, plus $30,000 of improvements. They move out and list it for rent on July 1, 2024, when it's worth $500,000. The land is 20% of value.

They sell in May 2027, within 3 years of moving out. Depreciation 2024 to 2027: about $4,400 + $9,600 + $9,600 + $3,600 (4.5 months) = $27,200. Sale for $580,000 with $35,000 of costs. Adjusted basis: $330,000 − $27,200 = $302,800. Gain: $545,000 − $302,800 = $242,200. The $27,200 of depreciation is taxed at up to 25%; the remaining $215,000 is excluded under their $500,000 limit. Federal tax: about $6,500 on the 1250 gain at their 24% bracket.

If they wait until 2028, the exclusion is gone, and $242,200 plus a few more years of appreciation and depreciation is taxable. That's tens of thousands of dollars for missing a date. Calendar it.

Illustration 2 (the down market): Lavish Larry bought at $450,000 and converts when the house is worth $400,000. His depreciable basis uses the $400,000 FMV (less land), not his $450,000 cost. If he later sells for $380,000, his loss is measured from the $400,000 FMV basis minus depreciation, not from $450,000. The $50,000 decline while he lived there is a personal loss, which the tax code never lets you deduct. Larry's lesson: the IRS will share your rental losses, not your homeowner regrets.

Keep, sell or convert? A quick framework

• Expected return: compare after-tax cash flow and appreciation to what the equity could earn elsewhere. See after-tax cash-on-cash.
• Tax clock: if gain is under the exclusion, keeping it beyond 3 years converts tax-free gain into taxable gain. That's a real cost of keeping.
• Distance and temperament: landlording from 1,000 miles away usually means a property manager, which changes the math.
• Mortgage: your loan was underwritten as owner-occupied. Most lenders allow renting after you've lived there the required time, but check. Update insurance to a landlord policy.
• Passive losses: above $150,000 MAGI, rental losses are usually suspended, so the depreciation benefit is deferred to the sale.