Should You Keep Your House and Become a Landlord?
BY: ETHAN LOHR, CFP® — November 13, 2025
Remember those interest rates in 2020–2021?
When everything else in the world generally stunk — this was a bright spot. It was also the time God allowed us to move into our family home as we were becoming a multiple-kid household.
Well, since that time, I’ve found myself doing what I hear my own clients say from time to time: “Man, I remember the good ole days.”
Those interest rates may be in the rearview mirror, but life still goes on. Whether you’re looking for a house with a couple more bedrooms and bathrooms or looking to relocate in retirement, you might not want to let go of that home (and mortgage payment) you locked in during COVID.
So, how do you turn this primary home into a profitable rental? Heads up: this is meaty. Enjoy some bold throughout to keep you focused.
Why Keep It in the First Place?
There are a few reasons people hang on to their old homes instead of selling:
Market Timing: Maybe your area’s “hot,” and you’d rather earn rental income while waiting for the next price surge.
Sentimental Value: Perhaps the home’s been in your family for generations (or you’re holding out hope one of the kids moves back someday).
Cash Flow Curiosity: That 3% mortgage from 2021 suddenly looks like an income-producing unicorn. Why give that up?
Whatever your reason, turning a personal home into a rental opens up both opportunities and tax complexity
The Magic (and Mayhem) of Taxes
Now that you’re officially collecting rent checks, the IRS has a name for you: a passive investor.
Most rental properties fall under this category, meaning the income you earn is considered passive activity income. In simple terms, it’s money you make without having to show up to an office or attend Monday meetings (which sounds great… until tax time).
Here’s the good news: depreciation — that slow, steady deduction we just talked about — helps lower the amount of income you actually recognize from your rental. Each year, you can deduct a portion of the property’s value, often enough to offset much (or all) of your rental income on paper.
That means you could have positive cash flow coming in but show a paper loss on your tax return. It’s one of the quirks that makes real estate so powerful.
But remember: there’s no free lunch in the tax code. Every dollar of depreciation you take reduces your cost basis in the property — and that will matter later when you consider selling. (We’ll unpack cost basis further below.)
“Active Participation” — The Retiree Advantage
For most people, rental income and losses are “passive,” which means you generally can’t use losses to offset wages, IRA withdrawals, or Social Security income. The IRS saves that special treatment for those who are truly in the business of real estate — people who spend 750+ hours a year managing properties and meet stricter “material participation” tests.
But here’s an interesting wrinkle — and one that works in many retirees’ favor because of their ability to control income sources and tax treatment.
If your Adjusted Gross Income (AGI) is below $100,000, and you “actively participate” in managing your rental, you can deduct up to $25,000 of passive losses against your other income.
As your AGI rises above $100,000, this deduction gradually phases out — disappearing completely once AGI hits $150,000.
“Active participation” is a much easier bar to clear than being a full-time real estate professional. You simply need to:
Own at least 10% of the property, and
Be involved in key management decisions — advertising the property, signing leases, coordinating repairs, or selecting tenants.
So, if you’re a hands-on retiree managing your own rental, this rule can help turn those “paper losses” from depreciation into real tax savings — up to $25,000 worth.
How Cost Basis Works (Yes, With Buckets)
Think of your property like a bucket of water — and you know I love a good bucket analogy. The water line represents your cost basis, the amount you’ve invested in the property. The top of the bucket represents the property’s sale price. The space between the water line (your basis) and the top (the sale price) is your gain.
When you make improvements — say, replacing the HVAC or putting on a new roof — you’re capitalizing the property. In our bucket analogy, that moves the water line up, filling more of the bucket and leaving less empty space at the top for taxable gain when you eventually sell.
Now, here’s where it gets interesting: depreciation slowly lowers that water line over time. It’s great in the moment because it reduces taxable income and boosts cash flow today. But each inch the line drops now means more “room” to reach the top— which translates to more potential gain recognized when you sell.
Capitalization = Good for basis, lowering recognized gain in the future
Depreciation = good for cash-flow, lowering recognized tax liability today
Sheltering the Gain: Five Ways to Keep More and Pay Less
So, you’ve got an appreciated property. That’s great news for your balance sheet… but it also means there’s a potential tax bill waiting if you sell.
Let’s look at a few tax-smart ways to navigate an appreciated property, from the classic homeowner exclusion to some more creative moves that can help you defer, reduce, or even erase the tax bill entirely.
1. The Capital Gain Exclusion Window — The Three-Year Rule
If you lived in the home for at least two out of the last five years, you can exclude up to $250,000 of gain if single or $500,000 if married filing jointly.
And here’s the kicker: that exclusion can still apply even after you’ve turned your home into a rental — as long as you sell within three years of moving out. Miss that window, and the exclusion disappears, making every dollar of gain taxable.
In other words: sell within three years, and the IRS lets you call it “home sweet home.” Wait too long, and it’s just “rental real estate.”
2. The 1031 Exchange — Deferring Taxes, Upgrading Property
If the three-year clock has expired or your gain is bigger than the exclusion allows, a Section 1031 exchange lets you defer the tax bill entirely by swapping your property for another like-kind investment property.
Think of it as a “real estate trade-in.” You’re not avoiding taxes forever — just kicking the can down the road. The property you buy takes on the old property’s basis, and the deferred gain follows you into the new investment.
Most tax pros recommend holding your home as a true rental for at least one to two years before attempting a 1031, to show the IRS it’s no longer a personal residence.
3. The Cost Basis Step-Up — The Legacy Reset
For retirees thinking long-term, this one’s powerful. In Four Buckets terms – this is a great Bucket 4 asset. When you pass away, your heirs receive a step-up in cost basis — meaning their new basis equals the property’s fair market value on the date of your death.
That step-up effectively erases all prior appreciation and depreciation recapture, allowing your heirs to sell the property with little or no tax.
It’s the ultimate tax reset — not one you’ll personally enjoy, but your kids sure will.
Two “Gray Area” but Smart Strategies
Now for the advanced plays. These aren’t for everyone, but they’re worth knowing — especially for clients who are within that three-year window or have a lot of appreciation locked up. Absolutely get a tax and/or legal professional involved for these.
4. Selling to an S Corporation You Own
Here’s the idea: you sell your former residence to a wholly owned S corporation that you control. As long as it’s done at fair market value and before your three-year exclusion window closes, the sale can still qualify for the $250k/$500k capital gain exclusion.
After that, the S Corp owns the property and rents it out — but with a new, higher basis or water mark like we just learned. Not only that, your depreciation schedule also resets but now with a higher value to work from. Think higher value divided by 27.5 (# of years for depreciation method) = bigger deduction.
This strategy comes with extra paperwork (and scrutiny), but when done correctly, it can be a win-win: secure the gain exclusion and reset the depreciation clock.
5. The “1152 Plan” — Combining Section 121 and 1031
This one’s a hybrid approach — a way to use both the primary residence exclusion (Section 121) and the 1031 exchange in the same move.
Here’s how it works:
You sell your former home that’s now a rental. The portion of gain up to your $250k/$500k exclusion is tax-free under Section 121. The rest of the proceeds roll into a 1031 exchange, deferring the remaining gain by reinvesting in another rental property.
Timing is critical: the property generally needs to have been rented for at least a year (to qualify for the 1031), but sold within three years of moving out (to qualify for the 121 exclusion). Done right, it’s a potent one-two punch — exclude what you can, defer what you can’t.
Final Thoughts: Turning Homes Into Income
Perhaps this topic has sparked a bit of curiosity — and maybe even a few ideas.
We’ve laid the groundwork to understand the financial side of turning a former home into a rental. But beyond spreadsheets and strategy, there’s another important layer: the real effort it takes to prepare, market, and manage a property.
I’ve been through that process myself — the repairs (meaning, I call someone), the lease listings, the decision-making. It can be rewarding, but it’s not without work/time.
What we love about this idea — whether you’re a younger investor looking to build income streams or a Four Buckets retiree doing the same thing in a new season of life — is that it all points back to the same goal: steady income that supports a purpose-filled life.
Enjoy this type of content?
Join our newsletter below and get it delivered right to your inbox.
