When a Home Becomes a Rental

Converting a primary residence into a rental property can be an effective wealth-building strategy, but the tax details demand some care. A recent Tax Court decision, Sherman Derell Smith v. Commissioner, T.C. Memo. 2025-24 (Mar. 24, 2025), illustrates how insufficient documentation can dismantle an otherwise legitimate deduction. The case serves as a reminder that turning a home into a rental is not simply a financial decision — it is a tax event requiring careful recordkeeping and valuation.

The Smith Case: What Happened and Why It Matters

In Smith, the taxpayer converted a former personal residence into a rental property and later claimed depreciation deductions. The property’s ownership history was complex, involving transfers within the family. When the IRS challenged his return, the only issue remaining was whether the taxpayer could substantiate his depreciable basis.

Under long-standing rules, when a property changes from personal to income-producing use, its depreciable basis is the lower of (1) its adjusted basis (original cost plus improvements, minus prior adjustments) or (2) its fair market value (FMV) at the time of conversion. Treasury Regulation § 1.167(g) and § 1.168(i)-4(b) codify this “lesser-of” principle.

The taxpayer in Smith failed on both fronts. He did not provide reliable evidence of either FMV or adjusted basis. His own estimate of FMV was unsupported, and he could not reconstruct the property’s cost history. The Court described his valuation as a “guestimate” that fell short of the precision required for depreciation deductions. Without proof of basis, the tax deduction was denied in full.

The lesson is straightforward: “basis drives depreciation,” and basis must be proven, not assumed.

Why Homeowners Convert — and Where the Risks Begin

Many homeowners choose to convert a primary residence into a rental property for various reasons-

• Preserving a historically low mortgage interest rate.
• Deferring capital gain recognition in a high-income year.
• Maintaining ownership during a temporary relocation.
• Positioning for future appreciation before an eventual sale (tax planning!).

While these motivations are logical, the conversion process carries hidden tax consequences. From a compliance perspective, a conversion triggers a change in use, which means a new basis calculation, a new depreciation schedule, and new reporting responsibilities. A failure to document that transition properly can mess up an otherwise perfectly good depreciation tax deduction, as seen in Smith.

Establishing Depreciable Basis at Conversion

The foundation of successful conversion planning is establishing a defensible depreciable basis. To reiterate, Treasury Regulation § 1.168(i)-4(b) dictates that the depreciable basis is the lower of adjusted basis or FMV on the date of conversion. This rule prevents taxpayers from depreciating unrealized appreciation that accrued while the property was used personally. Bummer, right?

For example:

• If a home was purchased for $300,000 and is worth $450,000 at conversion, depreciation must be based on $300,000 (the lower amount).
• If the home has declined in value to $250,000, the depreciable basis is $250,000, not the higher historical cost.

Easy math.

Documentation and Timing: The Practical Side of Compliance

The Smith decision demonstrates how the absence of documentation can unravel a taxpayer’s case. Several tax court cases hinge on recordkeeping and documentation- “your argument and tax position are sound, but your records are garbage.” The court usually finds a way to soften this.

An appraisal or broker opinion prepared contemporaneously (in real time) with the conversion is essential. In addition, records of purchase price, closing statements, and detailed lists of improvements must be maintained to support the adjusted basis calculation.

A structured conversion process might include:

• Professional Valuation – Obtain a dated appraisal or written market analysis at the time of conversion. Expensive, but a lock.
• Basis Reconciliation – Summarize purchase price, improvement costs, and prior depreciation (if any) in a basis schedule.
• Conversion Evidence – Retain proof that the property was made available for rent, such as listing records, lease agreements, or communications with property managers.
• Renovation Timing – Ideally, complete major renovations after the property is placed in service, so those costs can be capitalized into the depreciable basis.
• Formal Recordkeeping – Treat the conversion as a business event; maintain memos, appraisals, and correspondence for future substantiation.

Can a Zillow screenshot serve as a professional valuation? Unlikely. The courts have routinely considered the following to the gold standard-

• A licensed real estate appraiser’s report, dated close to the conversion date.
• A written broker price opinion (BPO) or comparative market analysis (CMA) prepared contemporaneously by a local real estate agent, ideally with MLS comps attached.
• County assessor data or certified appraisal records if contemporaneous and supported by comparables. This can be a challenge since assessment data is not fair market value.