I just went through this process last year. One important thing nobody's mentioned yet - if you decide to go the LLC route, be very careful about your mortgage. Most residential mortgages have a "due on sale" clause that can be triggered if you transfer the property to an LLC. The bank could technically call the entire loan due immediately. Some people do it anyway and just hope the bank doesn't notice, but it's a real risk. You might need to refinance with a commercial loan if you want to put it in an LLC, and those usually have higher rates and less favorable terms than residential mortgages.

The smartest approach I've seen is to wait until you've actually moved out, then do a proper "conversion to rental" by documenting the fair market value at that time (get an official appraisal!). Then form the LLC if you want and either: 1. Transfer the property to the LLC (watching for mortgage issues) 2. OR create a management agreement where your LLC manages the property but you retain personal ownership Option 2 gives you some liability separation without triggering the mortgage due-on-sale clause. Either way, don't try to deduct improvements made while living there as rental expenses - the IRS is very clear about this distinction.

One thing nobody's mentioned yet - if you're operating as an LLC, make sure you understand how you're being taxed. By default, a single-member LLC is treated as a disregarded entity for tax purposes, meaning you'll report business income and expenses on Schedule C of your personal return. In this case, you would still need to issue a 1099 for the business portion of rent if it's over $600. But if you've elected to be taxed as an S-Corp or C-Corp, the requirements are a bit different. Also, don't forget that starting in 2022, payment apps like Venmo and PayPal are issuing 1099-Ks for business transactions over $600, so if you're paying rent that way, it might already be reported.

Just wanted to add something important - make sure you keep documentation of all your attempts to get the W9 from your landlord. I had a similar situation and the IRS actually questioned my 1099 filing during a review of my return. I was able to show emails requesting the W9 multiple times, which satisfied them that I had made a "reasonable effort." Also, when you do get the W9, verify the TIN (Tax Identification Number) using the IRS TIN matching program if you can. Prevents headaches later if the information turns out to be incorrect!

Don't forget about state taxes too! Depending on your state, they might handle depreciation recapture and passive losses differently than the IRS. I live in California and was shocked to find out they have different rules for this situation. Anyone else have experience with state-specific handling?

For the official IRS guidance you're looking for, check out Publication 925 (Passive Activity and At-Risk Rules) - specifically pages 6-7 which cover the disposition of passive activities. This explains exactly how your $125K in carried forward passive losses become fully deductible when you sell the rental property. Also look at Publication 544 (Sales and Other Dispositions of Assets) which covers the depreciation recapture rules. The key point is that Internal Revenue Code Section 469(g) allows all suspended passive losses to be deducted in the year you completely dispose of your interest in the passive activity. You're right that they're separate calculations - you'll pay up to 25% on the $132K depreciation recapture, but you'll also get to deduct the full $125K in passive losses against your other income. So while you have about $7K in "economic profit," your tax situation will be quite different due to how these items are treated separately on your return. Make sure your tax preparer understands this - I've seen many get confused about how the passive loss suspension rules work upon full disposition of a rental property.

Just to add some possibly helpful information: there are actually some situations where portions of foster care payments might be taxable, which could be causing some of the confusion. If you receive payments that are designated as compensation for services rather than reimbursement for care, those could potentially be taxable. For example, if you're providing specialized therapeutic care and receive additional compensation above standard rates, that portion might be taxable. It might be worth asking the county if they're classifying any portion of your payments differently. In most standard foster care situations though, the payments are completely non-taxable as others have mentioned.

I'm a tax professional who's dealt with this issue multiple times. The county is definitely making an error - foster care payments are excluded from taxable income under IRC Section 131. What's particularly frustrating is that many counties have outdated systems that automatically generate 1099s for any payments over $600, regardless of the payment type. I recommend calling their finance department immediately with Publication 525 (pages 16-17) and IRC Section 131 ready. Ask to speak with both the Foster Care Program Manager and someone from their tax compliance team. Get any correction in writing, and if they refuse to fix it, document everything for your tax filing. You'll need to exclude the income and attach an explanation citing the IRC exclusion. Don't let this add to your stress - you're absolutely right that these payments shouldn't be taxable!

Has anyone successfully claimed property tax deductions without the 1098 showing it? I'm worried the IRS will flag my return if I claim property taxes that don't match what's on my 1098 form.

I went through this exact same nightmare last year! What finally worked for me was requesting an "escrow analysis" statement directly from my mortgage servicer - this is different from your regular mortgage statements and shows a detailed breakdown of all payments made from your escrow account throughout the year. Most servicers are required to provide this annually, but you can request it specifically. It will show every property tax payment made, even if your 1098 shows zero. I had to escalate past the first-level customer service (they didn't even know what I was talking about), but once I got to someone in the escrow department, they sent it right over. Also, keep your closing documents handy - they often show prorated property tax amounts that you paid at closing, which are also deductible but easy to overlook. Between the escrow analysis and closing docs, I found over $4,200 in deductible property taxes that weren't on my 1098.