Question 1

What is a cost segregation study and how does it work?

Accepted Answer

A cost segregation study is an engineering-based analysis that separates a rental property into its components, such as appliances, flooring, cabinetry, and landscaping, and moves them from the standard 27.5-year depreciation schedule into shorter five-, seven-, and 15-year recovery periods. Deductions arrive earlier, when they may be worth more. One caveat matters for converted homes: The 100% bonus depreciation restored by the One Big Beautiful Bill Act generally applies only to property acquired after Jan. 19, 2025, so the existing components of a home you bought years ago usually don't qualify for it.

Question 2

How does the Section 121 exclusion work when selling a primary residence?

Accepted Answer

The Section 121 exclusion lets eligible homeowners exclude up to $250,000 of gain, or $500,000 for certain married couples filing jointly, on the sale of a primary residence, provided you owned and used the home as your principal residence for at least two of the five years before the sale. Because the lookback runs five years, you generally have up to three years after moving out to sell and still qualify. You can't use the exclusion more than once every two years, gain above the cap is taxable, and depreciation taken during a rental period can't be excluded.

Question 3

Is a cost segregation study worth the cost for a converted home?

Accepted Answer

A study for a residential property generally runs between $3,000 and $15,000. It tends to pencil out when your depreciable basis clears roughly $500,000, you're in a high tax bracket, and you can actually use the deductions this year. Keep expectations realistic for a converted home, because the existing components usually don't qualify for 100% bonus depreciation, while the furnishings you buy after the conversion often do.

Question 4

How much of my home&#8217;s value can I depreciate?

Accepted Answer

Less than most people expect. When you convert a residence to a rental, your depreciable basis is the lower of your adjusted basis or the home's fair market value on the conversion date, and land is never depreciable. If you bought the property for $1.2 million and added $100,000 in improvements and the home is now worth $3 million, you depreciate from the $1.3 million adjusted basis minus the land portion, not from the $3 million.

Question 5

Should I convert my primary residence to a short-term rental before selling?

Accepted Answer

It may make sense to do so if you're near retirement, plan to relocate, own a highly appreciated property, have enough taxable income to use the deductions, and are comfortable running a rental for a limited period. It also depends on rules that are easy to overlook: the cap on your depreciable basis, the bonus depreciation acquisition date, material participation, local short-term rental ordinances, and depreciation recapture at sale. A wealth advisor and a tax professional can help you model whether the numbers work.

Question 6

Do I have to manage the rental myself?

Accepted Answer

Not necessarily on your own, but to keep the deductions from being suspended as passive losses, you generally need average guest stays of seven days or less plus material participation in the activity. Handing everything to a property manager typically works against that. Keep a contemporaneous log of your hours, since documentation is where these positions most often fall apart under IRS review.

Question 7

Where can I find help evaluating a home conversion tax strategy?

Accepted Answer

Look for a fiduciary wealth advisor who coordinates tax planning, investment management, and estate planning and who can model the depreciation benefit, the recapture cost, and the timing constraints together. Mercer Advisors offers comprehensive planning that coordinates these disciplines, including tax services through Mercer Advisors Tax Services, LLC.

Question 8

Where do I check whether short-term rentals are allowed at my address?

Accepted Answer

Start with your city or county planning department, which typically publishes short-term rental ordinances, permit requirements, and occupancy tax rules. Then check your homeowners association covenants and your mortgage documents, since an owner-occupancy clause can restrict rental use even where local law permits it.

Question 9

How do I report depreciation recapture when selling a converted rental property?

Accepted Answer

You generally report recapture on Form 4797 and Schedule D. Depreciation on the building comes back as unrecaptured Section 1250 gain at a maximum rate of 25%, while depreciation on furnishings and fixtures is recaptured under Section 1245 at ordinary income rates. A qualified tax professional can handle the reporting and coordinate the sale with the rest of your tax picture.

Question 10

What&#8217;s the difference between the Section 121 exclusion and a 1031 exchange?

Accepted Answer

Section 121 excludes up to $250,000 of gain, or $500,000 for certain married couples filing jointly, on the sale of a primary residence, with no requirement to reinvest. A 1031 exchange defers gain on investment property by reinvesting in another qualifying property, so the tax is postponed rather than eliminated. The conversion strategy leans on Section 121 for the residence portion, and depreciation recapture applies either way.

Question 11

How does converting a home to a rental compare with selling it directly?

Accepted Answer

Selling directly lets you claim Section 121 right away with no recapture and no rental to run. Converting first adds depreciation deductions that can offset other income, but it also adds recapture at sale, active management, local rule compliance, and a three-year clock on the exclusion. Conversion may produce a better after-tax result for highly appreciated homes when the timing works, and it may not be worth the complexity otherwise.

Question 12

How does this compare with holding the home for a step-up in basis?

Accepted Answer

If passing assets to heirs is already part of your plan, holding the property until death can step up the basis and erase both the unrealized gain and the accumulated depreciation recapture. That's a cleaner tax outcome than any version of the conversion strategy. The trade-off is liquidity and diversification, because the wealth stays tied up in one illiquid asset instead of funding your retirement income.

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Is a cost segregation study worth the cost for a converted home?

How does this compare with holding the home for a step-up in basis?

How does converting a home to a rental compare with selling it directly?

What’s the difference between the Section 121 exclusion and a 1031 exchange?

How do I report depreciation recapture when selling a converted rental property?

Where do I check whether short-term rentals are allowed at my address?

Where can I find help evaluating a home conversion tax strategy?

Do I have to manage the rental myself?

About Mercer Advisors

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Want to learn more about Mercer Advisors?

Protecting Your Legacy

Before You Sell Your Home, Consider This Tax Strategy

What Comprehensive Financial Planning Can Do for You

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How Women Can Design a Legacy That Reflects Their Values

How Much Money Do You Need To Work With a Wealth Manager?

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The Family Guide to Estate Planning: Helping To Protect What You’ve Built Across Generations

Tax Filing Is Not the Same As Tax Planning

The DINK Financial Advantage: Building Wealth Together

Expecting a Baby? What To Know Now

Is a cost segregation study worth the cost for a converted home?

How does this compare with holding the home for a step-up in basis?

How does converting a home to a rental compare with selling it directly?

What’s the difference between the Section 121 exclusion and a 1031 exchange?

How do I report depreciation recapture when selling a converted rental property?

Where do I check whether short-term rentals are allowed at my address?

Where can I find help evaluating a home conversion tax strategy?

Do I have to manage the rental myself?

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