(Citations: IRC §§121, 167, 168, 280A; Treasury Regs §1.121-1, §1.168; IRS Pub. 527)
Most people understand what happens when you convert your home into a rental… but far fewer understand the opposite scenario: Turning a rental property back into your primary residence.
This shift brings several IRS rules into play, especially around depreciation, cost segregation, tax basis, and the rules for excluding gain when you eventually sell the property.
Here’s what you need to know before you make the switch.
Depreciation Stops on the Day You Convert It to Personal Use
Under IRC §167(a), depreciation is allowed only while a property is used in a trade or business or held for the production of income.
When the property becomes your residence:
- Depreciation stops immediately.
- The property is no longer in service as rental real estate.
- You cannot claim any depreciation or related deductions going forward.
But your previous depreciation doesn’t disappear.
The IRS will remember it when you sell the property (more on that below).
Your Tax Basis Is Adjusted for Prior Depreciation
When a rental becomes a personal residence, the personal-use years do not add to or restart your basis. Instead, the IRS requires the following:
Your property’s adjusted basis going forward becomes: Original basis + improvements − depreciation allowed or allowable
“Allowed or allowable” (IRS term under §1016) means: Even if you didn’t take depreciation you were entitled to, the IRS reduces your basis as if you had.
This is important because it affects:
- Capital gain calculations
- Depreciation recapture later
- Your exclusion eligibility under §121 when you sell
What Happens if You Previously Completed a Cost Segregation Study?
If you performed cost segregation during the rental period: Those accelerated deductions stay locked in.
Nothing is reversed.
However:
You will have §1245 recapture later on the components originally identified as:
- 5-year property
- 7-year property
- 15-year land improvements
These amounts are taxed at ordinary income rates (up to 37%) when you eventually sell the property, even though you are now living in it.
And the residential-use years do NOT convert those assets back into long-life property.
They simply:
- Stop depreciating
- Carry their adjusted basis into the future sale calculation
Can You Still Use the §121 Exclusion When You Sell?
(The “$250k / $500k home sale exclusion”)
Yes, but with major limitations.
Under IRC §121, you can exclude up to:
- $250,000 of gain if single
- $500,000 if married filing jointly
…but ONLY if you meet:
- 2 years of ownership
- 2 years of use as a primary residence in the 5 years before the sale.
However, rental-to-primary conversions face two restrictions:
4a. Depreciation Recapture Cannot Be Excluded
IRC §121(d)(6): Any gain attributable to depreciation deductions taken after May 6, 1997 cannot be excluded.
Translation:
- All depreciation you took while it was a rental
- PLUS all the cost segregation accelerated depreciation
→ Fully taxable at sale
→ Cannot be shielded by §121
4b. “Nonqualified Use” Reduces the Exclusion
Under IRC §121(b)(5), periods of rental use after 2008 reduce the amount you can exclude.
Nonqualified use = Years the property was not used as your primary residence after 2008.
This means if you bought the property as a rental, then lived in it later: Your gain exclusion is prorated.
Example formula: Qualified use gain = Total gain × (qualified use years ÷ total ownership years)
Depreciation recapture still applies separately.
What Happens to Bonus Depreciation?
If you previously took bonus depreciation:
- It remains intact
- You never have to “pay it back” until you sell
- But all bonus depreciation is subject to ordinary income recapture
Your personal-use years do NOT erase bonus depreciation.
Practical Example
Original purchase (as rental):
- Cost (allocation to building): $400,000
- Cost segregation accelerated depreciation: $80,000
- Regular depreciation: $30,000
- Total depreciation taken: $110,000
Converted to primary residence:
Adjusted basis becomes: $400,000 − $110,000 = $290,000
You live there for 5 years.
Later sale:
Sale price: $600,000
Gain before exclusions: $600k − $290k = $310,000
IRS applies rules:
- $110,000 depreciation recapture
→ Taxed at your ordinary rate (up to 37%) - Remaining $200,000 subject to §121 exclusion
→ Exclusion reduced for nonqualified rental years
Even if you qualify for the full $250k/$500k exclusion, the $110,000 recapture is always taxable.
Key Takeaways
✔ Depreciation stops at conversion
✔ Basis is permanently reduced by all prior depreciation
✔ Cost segregation is allowed, but recapture is unavoidable
✔ §121 exclusion is prorated for rental years
✔ Depreciation recapture is always taxable
✔ Bonus depreciation stays intact but is recaptured at sale
Thinking of Making the Switch?
Engineered Tax Services can help you:
- Understand your recapture exposure
- Model your basis and eventual gain
- Determine whether cost segregation and rental years have created tax efficiency
- Plan the smartest timing for selling or converting the property
We offer a complimentary benefit analysis and full LearningHub to help you make informed decisions; however, please consult your CPA for tax guidance and how these rules apply to you personally.
