Turning your home into a rental

There is a day when your home starts being a rental — not for every purpose in the tax code, but for how it is depreciated, reported and eventually sold. Nothing arrives in the mail to mark it. Nothing is due that day. Nobody asks you for a number.

That is the problem. The conversion day is the one moment when several facts about the property are cheap to establish, and every one of them gets harder — occasionally impossible — to establish afterwards. This article is about what to write down and why.

It is not about what renting does to your home-sale exclusion. That is a separate question, it has a real answer, and it turns on the order of events rather than on the conversion itself. It has its own article, and if that is the question you arrived with, start there.

Nothing happens on a return that day

Converting a home to a rental is not a sale. Nothing changes hands and no money moves, so the conversion is not a taxable event: there is no gain or loss to report on it. What it does produce is a number — the basis your depreciation runs from — and that number is established on the conversion day, then reported for the first time on a return filed the following spring, since depreciation on property placed in service during the year is claimed on Form 4562 (Instructions for Form 4562). No document arrives on the day itself to prompt you for it.

Meanwhile the tax treatment of the property has changed completely. Until that day it was an asset whose adjusted basis you were quietly accumulating and would only need once, at sale. From that day it is an asset that is depreciated, generally reported annually on Schedule E, and eventually sold under a different set of rules again.

A silent day that changes everything is the worst combination a record can have. Nobody forgets to keep the closing file. Almost everybody forgets the conversion, because nothing about it feels like an event.

Fair market value, on the date of the change

Fair market value is defined plainly enough: the price at which property would change hands between a buyer and a seller, neither having to buy or sell, and both having reasonable knowledge of all necessary facts (Publication 551).

The date that matters is the date the use changed — not the day you decided to rent it out, not the day the lease was signed, and not the day the first payment cleared. Those are usually three different days, and people tend to remember the last one.

The publications define fair market value; they do not hand you a method for proving it. What people rely on is an appraisal dated around that time, a written opinion of value from an agent, or the comparable sales that were actually on the record then. All of those are ordinary to obtain in the week you convert.

Years later, none of them is ordinary. A valuer can be engaged to reconstruct a past date, and that is a real service that produces a real report — but you are paying someone to excavate a number you could simply have written down, and a reconstruction is inherently more arguable than a contemporaneous document.

Why that number matters: the lesser-of rule

Here is the rule that makes the conversion day worth this much attention. Where you held the property for personal use and then changed it to rental use, the basis used for depreciation is the lesser of your adjusted basis on the date of the change, or the fair market value on that date (Publication 527, Publication 551). The publications state that rule for the property; their worked examples run it on the building alone, after the land has come out of both sides. That ordering has its own section below, and it changes the answer.

So fair market value is not decoration. It is one of the two candidates, and where the property is worth less that day than it has cost you — purchase plus qualifying improvements — it is the one that wins. That is not the same question as whether the market rose since you bought: the comparison is against your adjusted basis, and a large addition can put adjusted basis above value in a market that went up. A comparison you cannot evidence is a comparison somebody has to make on assumptions instead.

It is worth being precise about what the lesser-of figure is and is not. It is the starting point for depreciation. It does not become your basis for everything. On a later sale, Publication 551 puts it this way: the basis for figuring a gain is your adjusted basis, while the basis for figuring a loss starts from the smaller of adjusted basis or fair market value at the time of the change, then adjusted for the period after it.

Which means a converted property can carry two numbers for the same asset, and which one applies depends on how the eventual sale turns out. That is genuinely a matter for your tax professional. What is not negotiable either way is that both numbers trace back to the same afternoon.

The comparison happens once, on a date that has already passed by the time anyone asks you about it. There is no way to re-run it. Whatever you can show about the property that day is what you have.

The placed-in-service date

Property is placed in service in a rental activity when it is ready and available for a specific use in that activity — and, as the publication puts it, even if you are not using the property, it is in service when it is ready and available for its specific use (Publication 527, Publication 946).

That is a different idea from having a tenant. A house that is cleaned, listed and available can be placed in service before anybody signs anything and before a dollar of rent arrives. The date is a fact about readiness, not about occupancy.

It matters because depreciation runs from it. Residential rental property under the General Depreciation System has a 27.5-year recovery period, using the straight line method and a mid-month convention (Publication 527) — a convention that cares which month you started, which is precisely the kind of detail that is obvious in the moment and vague in five years.

Write down the date and, in a sentence, what made it that date. “Final clean done, listing live” is worth more later than the date on its own.

On a conversion this is also the date the fair market value above is measured on. Publication 527 says to treat the property as placed in service on the conversion date, so one date does both jobs. The house that sat empty for months before you let it is not an exception: the publication works that case, and the date it lands on is the day the property was listed and available, not the day you moved out (Publication 527).

The day you moved out is a real date all the same, and a different one. It closes the period the property was your residence, and the timeline needs it — even though no depreciation runs from it.

The land and building split

Land is not depreciated, because land generally does not wear out, become obsolete or get used up (Publication 527). So the split is not something done afterwards to the answer. It comes first, and it has to be done on both sides.

The worked examples are explicit about the order. Because land is not depreciable, you include only the cost of the house when figuring the basis for depreciation — and the lesser-of comparison is then run on the house alone, the house’s adjusted basis against the house’s share of the value on the date of the change (Publication 527, Publication 551, Publication 946). Comparing the two whole-property totals and splitting the winner afterwards is a different sum, and it can land on a different number.

Which is why the conversion day wants the value broken into land and building rather than given as one total. It costs nothing to ask for while somebody is valuing the property anyway, and the purchase side needs its own split as well, from back when you bought.

The publications do not give a method for splitting a conversion-day value. What they set out is the allocation for a purchase — the fair market value of each asset against the fair market value of the whole, and, where you are not certain of those values, a fallback of dividing on the assessed values for real estate tax purposes (Publication 527, Publication 551). Borrowing a purchase rule for a conversion is a judgement to settle with your preparer rather than alone. Either way the split tends to follow the property for its whole life, so record the reasoning alongside the number — which assessment, from which year, or which appraisal.

The building is not necessarily the only depreciable asset either. Appliances, carpeting and furniture used in a residential rental are 5-year property, separate from the 27.5-year building (Publication 527). If the fridge and the washer stayed with the house, they are their own lines — and the same comparison applies to each of them: what it cost you against what it was worth that day. Which classes exist and what belongs in each is the subject of a separate article.

Basis does not reset

The years the property was your home are not a blank page that the conversion wipes. Adjusted basis is one of the two numbers in the lesser-of comparison, and adjusted basis is built from the purchase and from qualifying improvements you made while you lived there.

Which means the box of receipts from the years it was just your house has quietly become load-bearing. Bring the history forward on the conversion day, while you still remember what the 2019 invoice was for.

Three cautions when you do:

• Repairs are not improvements. Work that kept the home in ordinary condition generally did not add to basis, however much it cost. The line between them has real gray areas, and they are worth reading before you total anything up.
• Some improvements have already left. An improvement that is no longer part of the home generally drops out of adjusted basis (Publication 523). The kitchen you replaced twice counts once.
• Some things reduce it. Energy credits, rebates, and insurance or casualty payments generally come off adjusted basis rather than adding to it (Publication 551). Bringing the improvements forward without them produces a number that is too high, and too high is the direction that gets questioned.

And note that from the conversion forward, the same question of repair against improvement flips its consequence. On a rental, an ordinary repair is generally a deductible expense in the year you pay it, while an improvement — broadly, work that betters the property, restores it, or adapts it to a new or different use — is capitalised and depreciated (Publication 527). Same distinction, opposite pull, and now it matters every single year rather than once at sale.

Converting back is a dated event too

A property is not stuck in the use you last gave it. Moving back in, withdrawing it from the rental market for good, or letting a family member live there rent-free is another change of use, with another date — and a property can move between uses more than once over a long ownership.

A gap between tenants is not one of these. A property that is vacant but still held out for rent has not changed use, and Publication 527 is explicit that depreciation continues while the property is temporarily idle — including while you make repairs after a tenant moves out (Publication 527). Recording a change of use on the day the last tenant left would put a wrong date on the timeline, and a wrong date here is worse than a missing one. Giving the property away is a different thing again: a gift is a disposition with its own basis rules, not a change of use.

Each stretch is its own period with its own treatment, and depreciation taken during a rental period does not evaporate when the property becomes a home again. The exclusion consequences of that direction of travel are covered in the article on renting and the exclusion. The records point is simpler and applies regardless: what a preparer eventually needs is a timeline, dated at both ends of every period, kept as it happened rather than reassembled from memory.

What to capture that day

Everything above reduces to a short list. None of it takes an afternoon on the day; all of it takes an afternoon later, and some of it cannot be recovered at all.

• Fair market value at the date of the change, and the document behind it — the appraisal, the agent’s written opinion, or the comparable sales as they stood that week
• The land and building split, on both sides — how the conversion-day value divides between land and building, and how the original purchase divided, with the source of each allocation noted rather than just the resulting figures
• The placed-in-service date, and a line on what made the property ready and available
• Your adjusted basis going in: the purchase documents, plus qualifying improvements from the years it was your home, dated and receipted
• Appliances and furnishings that stayed, listed separately — what each cost you, and what it was worth that day, since the same comparison applies to each of them
• Photographs of the property’s condition, which cost nothing and are the only evidence of that day nobody can reconstruct
• The date the previous period ended — the last day it was your residence — because the timeline needs both ends

Two of those are already in HomeBasisLedger for every owner, free. Recording that a property became a rental asks for the date it changed and, on a rental, what it was worth then and where that figure came from — and it keeps the periods as a dated history rather than as a setting that overwrites what came before, so the end of one period and the start of the next are both on the record.

The rest is what the Investor add-on adds, at $9.95/month, with Pro included. On a property marked as a rental it records a land value with the source of the figure, and the date it first became available to rent; rent received; security deposits tracked separately from income, because they are not the same thing; operating expenses against Schedule E lines; and improvements grouped by depreciation class with a subtotal for each. Every tax year produces a file you can download listing every Schedule E line, zeros included, so what is absent is visible rather than merely missing.

What it does not do is work out depreciation. There is no schedule, no MACRS arithmetic, no Form 4562, and Schedule E line 18 is deliberately absent from every report. The depreciation class attached to an improvement is the conclusion you and your preparer reached, written down where it can be found again. The product keeps the record. The conclusions stay with the person qualified to reach them.