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I ended up taking the home off the market. I think that this is really a bad time to sell and realize the losses. My crystal ball does not tell me if prices will recover sufficiently before the 2.5 years after which I would have to pay capital gains and depreciation recapture on the sale, but I'm hopeful that there will be some good appreciation over a longer period, possibly enough to make it worthwhile and pay for said taxes.

I put the home with a management company. I hope it will be rented within a few weeks. I am doing a no-cost refi at 4.5% on a 7 year ARM as a non-owner-occupied property. The principal and interest payment will be $1266. That is double the $625 interest-only payment on the line of credit currently. But I won't have to worry about interest payments going up. 7 years should be enough time for prices to recover to some acceptable level. Even after that, the lifetime rate cap is 9.5% . The lifetime rate cap is 18% on the current HELOC.

The higher payment means that the property will be cash flow negative for at least the first year. I put in 4.5% vacancy rate for the county, 8% management fee, $200 for maintenance, the current HOA monthly fees and insurance rate, and came up with $261 per month cash flow negative the first year. On the first payment on the new loan, there will be $329 of principal payment. So, it's not really losing money, unless property values drop further, and I'm betting that within the next 7 years, they will be higher than now.

I have been reading more about the tax rules. It seems that only the depreciation that was taken is recaptured and taxed as ordinary income. But if there is other appreciation, it's still taxed as a capital gain. So the penalty for selling after september 2013 is not quite as bad as I previously thought. I will still try to sell before in 2 years if market conditions are good, of course, but if not I will continue renting out.

Apparently, the IRS rules may consider me an "active manager" if I make decisions such as setting the rent. I don't have to be managing every detail of the property, the property management company will do that.

Lastly, thing is that my partner and I are going to finally enter into a California domestic partnership this year. The rules for gay and lesbian couples are very complicated, and we can't file jointly for federal purpose, but we have to add our incomes and deductions, divide by two, and then file separate federal returns. Because my partner earns much less than me, this means that I will be regarded as a much lower earner on my 1040, less than 6 figures, and will be able to fully deduct all the losses from depreciation and other rental losses every year. I will be in a lower tax bracket and my partner in a higher tax bracket. The effective tax rate will be lower. With no rental losses, and about 7000 of depreciation, the deduction should be worth at least 2500, so in the end it would be close to cash flow neutral after taxes. Of course that depreciation would be recaptured eventually upon sale.
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