Is this legitimate for rental property?

Property A&B, identical, across the street from each other.
Adam owns Property A, Bob owns Property B.

Adam and Bob (brothers) don't like the fact that they cannot deduct expenses (besides interest)from owning their own properties (like depreciation). As a result, Adam moves into Bob's house, Bob moves into Adam's.

Now, after depreciation, each brother is taking a loss from investment property and therefore pays less taxes. Nothing has changed in terms of expenses - all payments remain the same, but now they both have a small tax loss to offset their wage income.

Does this seem right? Is it legitimate? Why doesn't everyone do it? Other than depreciation recapture (they both plan on selling within 3 or moving back for 2 to take the 250k exclusion) what else am I missing?

In a nutshell, these guys cannot deduct their own expenses (to be able to take a loss on tax return), so they just swapped houses, everything else remains the same.

Bottom line, if they were not related, I know it is legitimate. It is completely reasonable for me to move out of my primary residence and move into another property that will I rent. It is also reasonable for me to rent out the property that I own, and take a loss after depreciation deductions.

The only question is, can I do this swap with just anyone? Where are family members excluded?

There is a principle in income taxation: If you do something without a sound business reason as your primary motive, you cannot get a tax benefit from it.

Here, your primary motivation is to reduce your taxes. There is no business reason whatsoever ( there might be if they lived in different cities for example & the trade would bring them closer to their jobs). But that's not in your scenario.

Sorry, no, not as you describe the facts.

I think you are minimizing the effects of the depreciation recapture, especially if they are going to sell within 3 years, and even if they move back in and make the income property their primary residence again.

Good question. You get the benefit of deducting expenses that are otherwise non-deductible (like utilities, insurance, repairs etc.). But it comes down to this:

The rental has to have a legitimate business purpose. So, if the rental is set up with a purpose of tax avoidance, then the IRS could say that it is not a legitimate rental. They use substance over form on this type of test.

For example. Does it make business sense to rent somebody else's place when you have a place of your own right accross the street? Probably not.

Several things, possibly. First off, the actual rent paid MUST be a fair market rental for the area. Be prepared to defend the amount of the rent that is being paid. Have it thoroughly documented! If rents are high in your area relative to mortgage payments then you may have a taxable GAIN in the rental activity.

When you sell, the depreciation allowed or allowable must be subtracted from your cost basis. This increases your gain on the sale. This amount WILL be taxed as a capital gain REGARDLESS of any entitlement to the exclusion amount. Keep in mind the term "allowable" as if you don't claim the depreciation deduction you STILL must deduct an amount equal to what would have been allowable had you taken it. So if you had $200k in excludable gain but had $20k in depreciation allowed or allowable, you'll pay tax on the $20k