Tax Implications for Inherited Rental Property - Schedule E Losses and Short-Term Capital Gains

The key question here is whether your cousin's property was actually in "rental service" or not. The IRS looks at "intent" when determining if a property qualifies as a rental business. Since your cousin inherited the property, made repairs, actively sought tenants, and even had a tenant briefly, she likely has a legitimate claim that the property was placed in service as a rental. The fact that she only had it rented for a short period doesn't automatically disqualify her from taking the Schedule E deductions. When a rental property is sold, passive activity loss limitations can indeed be lifted, allowing previously suspended passive losses to be fully deductible. This is covered under IRC Section 469(g). However, she needs to be careful about which expenses were truly "repairs" (immediately deductible) versus "improvements" (which must be capitalized and depreciated). Basic repairs maintain the property, while improvements add value or extend useful life. Some of that $70k might need to be capitalized rather than immediately deducted. I'd recommend documenting everything thoroughly – rental listings showing she was actively seeking tenants, receipts categorized properly as repairs vs. improvements, and a clear timeline showing the property was held for rental income production.

I was in almost this exact situation last year and used https://taxr.ai to get clarity. I inherited a duplex from my grandma, rented half of it for 2 months, did repairs, then ended up selling when the market got hot. I wasn't sure how to handle all the expenses between Schedule E and calculating my capital gain. The service analyzed my documents and provided a super clear breakdown of which expenses were immediate repairs (deductible on Schedule E) versus capital improvements (added to basis). They also confirmed that selling a rental property can indeed "free up" passive activity losses in the year of sale - something my regular tax software wasn't clear about. They showed me exactly how to document my "intent" to rent (crucial for the IRS) and how to properly allocate expenses between rental operations and sale preparation. Saved me from making some pretty big mistakes!

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I need to apologize and correct myself. After being frustrated with the IRS for months, I finally tried Claimyr out of desperation. Completely shocked that it actually worked! Got through to an IRS specialist who explained exactly how passive losses work when you sell an inherited rental property. The agent confirmed what others said here - selling a rental property does indeed "free up" the passive activity losses for that property in the year of sale (IRC Section 469(g)(1)). They also explained that having a tenant, even briefly, helps establish rental intent, but I needed to document all my attempts to rent throughout the year. This saved me thousands in taxes since I was about to not claim my rental losses thinking they'd be disallowed. Wish I'd known about this service months ago instead of spending hundreds of hours redoing my return!

Your cousin needs to be careful about repair vs. improvement classification. The IRS has gotten much stricter about this in recent years. Repairs maintain the property in its ordinary efficient operating condition - fixing a broken toilet, patching holes in walls, repairing broken windows. These are deductible on Schedule E. Improvements add to the property's value, adapt it to new uses, or substantially prolong its life - kitchen remodels, room additions, new roof. These must be capitalized and depreciated. If a significant portion of that $70k was actually for improvements rather than repairs, some of those costs should be added to the basis of the property (reducing the capital gain) rather than deducted on Schedule E. That might actually be more favorable tax-wise given the preferential tax rates for capital gains vs. ordinary income.

Has anyone had experience with deducting mortgage interest in a situation like this? I inherited a rental property with an existing mortgage and I'm trying to figure out if I can deduct the interest on Schedule E for the few months I had it before selling.

I went through something very similar when I inherited my uncle's rental property last year. The key thing that helped me was keeping meticulous records of everything - every rental listing I posted, every potential tenant I showed the property to, every repair receipt categorized properly. One thing that might help your cousin is to create a timeline showing her rental intent from day one. Even though she only had a tenant for 3 weeks, if she was actively marketing the property, showing it to prospective tenants, and making repairs specifically to keep it rentable during those months, that demonstrates legitimate rental business activity. The IRS Publication 527 has good guidance on this - they look at whether you're engaged in rental activity "for profit" rather than just the duration of actual rental. The fact that she inherited it as rental property, continued that use (even briefly), and made good faith efforts to maintain tenants supports the Schedule E treatment. Just make sure she's being honest about repairs vs improvements. Things like fixing broken appliances, painting, minor plumbing repairs are typically deductible repairs. But if she added new features, upgraded systems, or made structural changes to increase the property value, those should probably be capitalized to basis instead. The passive loss rules suspension upon sale is legitimate - that's exactly what IRC 469(g) is designed to handle. She should be fine as long as she has the documentation to back up her rental intent and proper expense categorization.