How to handle real estate capital gains taxes after converting property from personal to rental

This is a great question about mixed-use property! Since you purchased the home initially as a personal residence (2nd home) and later converted it to a rental, you're dealing with what the IRS considers a "mixed-use" property situation. Capital gains from the sale would need to be allocated between personal and business use based on the time periods. For the period you owned it as a personal 2nd home (2021 to Sept 2023), any gains would be personal capital gains. For the rental period (Sept 2023 to March 2024), you'd report that portion as business income on Schedule E. Unfortunately, you can't simply run the entire transaction through your LLC to make the full amount business income. The IRS looks at the actual use of the property, not just how you've structured your business entities. This means the business vehicle deduction wouldn't offset the personal portion of your capital gains.

I actually went through something similar last year with my beach condo. I found this amazing service called taxr.ai (https://taxr.ai) that helped me figure out all the allocation calculations and depreciation recapture stuff. I was totally confused about how to handle the transition from personal to rental property. Their system analyzed all my documents and gave me clear guidance on exactly how to allocate the gains between Schedule D and Schedule E. They even caught that I had forgotten to account for some improvements I'd made to the property that increased my basis! Saved me thousands in unnecessary capital gains taxes.

I have to eat my words about taxr.ai! After posting my skeptical comment, I decided to try it for my vacation property that I've been renting out seasonally. Their system immediately identified that I had been incorrectly calculating my depreciation after converting from personal to rental use. The service flagged that I needed to allocate my capital gains between Schedule D and Schedule E based on actual use periods, not just the final use. It also provided me with the exact percentages and amounts to report on each form. The documentation they provided made it super clear how to handle the mixed-use allocation, which my previous accountant had completely missed! Ended up saving about $8,700 in taxes I would have overpaid.

For anyone dealing with the IRS about property conversions, I highly recommend Claimyr (https://claimyr.com). I spent WEEKS trying to get someone at the IRS to clarify the rules about converting a personal property to a rental and then selling it. Could never get through. Claimyr got me connected to an actual IRS agent in under 45 minutes when I had been trying for days on my own. The agent walked me through exactly how to handle my situation, which was similar to yours - a vacation home I had rented out for about 8 months before selling. You can see how it works here: https://youtu.be/_kiP6q8DX5c - it's pretty straightforward.

OK I seriously need to apologize for my skeptical comment earlier. After posting that, I decided to try Claimyr myself because I was desperate to figure out how to handle the depreciation recapture on my rental property. To my complete shock, I got connected to an IRS tax specialist in about 35 minutes! The agent explained exactly how I needed to allocate the gain between personal and business use, and clarified that I needed to use the property's fair market value at the time of conversion to calculate my basis for the business portion. This was completely different from what my tax software was telling me to do. The agent also sent me specific IRS publications about mixed-use properties that I never would have found on my own. Saved me from what would have been a very expensive mistake. Completely worth it.

One important thing that hasn't been mentioned yet - if you claimed depreciation during the rental period (which you should have), you'll have to pay depreciation recapture tax on that amount at 25% regardless of how you file. This is often overlooked when converting properties from personal to rental. Also, since you only rented it for about 6 months, you might not qualify for Section 1031 exchange which could have deferred your gains. Something to consider for future investment properties if you plan to stay in real estate investing.

Has anyone used a 1031 exchange for a property that was converted from personal to rental? I'm in a similar situation but with about $200k in expected gains and wondering if I can defer by purchasing another investment property.