Personal Residence To Rental Property

Question

Personal residence purchased in 2009 for $75,000.00 and lived in home until last year 2025. My daughter was single when she purchased the home and lived there single until she moved out. Last year she moved into her boyfriend's home, and they fixed up her house to use as a residential rental property. At the time she started getting it ready to rent the home out, it was valued at about $330,000.00. With the basis of the home and over $5,000.00 in repairs to get ready for rent, am I correct in understanding that she will not have to pay capital gains if she buys it from herself?

Here is what I THINK we can do. Please let me know if this is wrong.

If I loan her $330,000.00 against her now rental property at 3.5%. She can then take that money with her now husband (Married in 2025) and she can purchase a home with him. In this scenario she will be able to write off the interest paid against the rental property along with her other rental expenses. Her new basis for the rental property would be $330,000.00.

Is there anything not ok or wrong with doing this?

Are there any legal rules about what kind of paperwork needs to happen or that may need to be recorded?

I want to make sure we do this right.

GeorgeM · Answer

Hello Cami:

Regarding depreciation, the cost basis for the rental property would be what your daughter paid for the property, which based on your post, was $75,000.  To the cost basis, your daughter could add any closing costs, title insurance fees, legal fees, etc.

In terms of the rental property’s cost basis, any outstanding mortgage is not relevant as that type of expense is part of the overall operating expenses for the rental property.  Those overall operating expenses, including any mortgage interest, are reported on Schedule E.

You are correct in that if your daughter should convert the residence to a rental property, and it remains a rental property for more than three years, then any sale of the rental property after that three year period will void any capital gain exclusion.  We have a great article that discusses the sale of a rental property that was previously a personal residence and you can find that article here:

https://community.freetaxusa.com/kb/articles/321-how-do-i-report-the-sale-of-my-home-if-it-was-also-used-as-a-rental#:~:text=

Regarding selling the property to a single member LLC (SMLLC), that type of sale is not advisable given that the IRS essentially treats a SMLLC as the “alter ego” of the taxpayer.  However, there may be another entity type in which your daughter does not hold the majority interest, and where a sale of the property can be effected.  However, any recommendation we might suggest here is beyond the scope of advice we can offer.  Thus, you would need to seek advice from your own tax advisor.

Lastly, for the capital gain exclusion to apply, there is the “ownership" test and the “use” test.  Only one spouse needs to satisfy the ownership test and it appears your daughter meets that test.  In terms of the use test, both spouses must have used the home as a residence for at least 24 months (2 years) of the previous 5 years before the sale to satisfy the use test.  The IRS has some useful information on the sale of a home and the capital gain exclusion which you can find here:

https://www.irs.gov/taxtopics/tc701

Cami · Answer

Hello George,

This information is very helpful. I certainly don't want to do anything illegal or wrong.

If she bought the home in 2009/2010 for $75000.00 (and lived in the home until now) but only owes $40,000 on it when it turns into a rental…is the basis for depreciation the $75,000.00 or the principal amount owed at the time it turns into a rental?

Here is my big concern for her. I am hoping that someone can tell me the best way to help her navigate through this to not lose the capital gains exclusion.

The house is worth roughly $250,000 more than she paid for it. If she sells the house now, she will not have to pay capital gains tax on it. What happens to that capital gains exclusion if she rents it out. Does she forfeit that? I read online that she can rent it out for up to 3 years before losing that exclusion. Is that true? Is there a way she can rent it out longer and still get that exclusion when she sells?

Another thought….

Is it ok for her to open a one member LLC and get a business license and then sell her personal home to her business? If the business could get a loan to pay her off personally? Is this allowed?

I am looking for any and all suggestions on how she can rent out her personal residence but not lose her capital gain exclusion.

Thank you for your help!!

GeorgeM · Answer

Hello Cami:

For the most part, what you are proposing cannot be done.  With regard to your daughter’s home—soon to be rental property—the basis of that rental property in terms of depreciation will be the lesser of two amounts: the properties adjusted cost basis and the properties fair market value.  Whichever amount is the lesser amount, that is the amount that is entered into our software, and the applicable depreciation expense is based on that lesser amount.

It’s likely that the adjusted cost basis of the property, that is its original purchase price of 75,000, plus any renovations, will be the lesser amount given that the FMV appears to be much greater.

Your daughter cannot purchase the property because your daughter already owns the property.  Transactions of this type generally lack economic substance and may be viewed as a sham transaction with the intent of tax evasion.

You could loan money to your daughter and the both of you could agree to use the home as collateral for the loan.  Additionally, unless you place certain restrictions on the loan, your daughter could use the loan to purchase a new home.  However, if the loan is used to purchase a new home, any interest that your daughter pays you cannot be fairly characterized as a rental expense given that the loan proceeds were not used for the rental property, but rather were used to purchase a personal residence.

If you decide to follow through on giving your daughter a loan so that she can purchase a new home, any interest that she pays you needs to be reported as interest income on Schedule B to your Form 1040.  Although you do not need to issue a Form 1098 to your daughter, you will need to give your daughter some type of mortgage interest statement that shows the amount of interest she paid you.  If your daughter takes the standard deduction on her personal tax return, then any interest she pays you will not affect her tax return.   However, if she can itemize her deductions, then your daughter will use the mortgage interest statement in the same manner as if she had received Form 1098 from a lending institution.