1) Yes, because your tenant pays fair market rent and uses the townhouse as her main home, this is considered a rental property. Otherwise, this would be considered personal use per the IRS (see What is a day of personal use? #2).
2) Yes, you can convert this to personal use. There is no exclusion for fair market rent paid by a related party who uses the property as their main home - the income must be reported as rental income.
IRS Not Rented for Profit:
- "If you don’t rent your property to make a profit, you must still report your rental income, however, you can no longer deduct rental expenses."
- "If your rental income is more than your rental expenses for at least 3 years out of a period of 5 consecutive years, you are presumed to be renting your property for profit."
3) Reimbursement of expenses would not be considered rent as long as the activity was not an intent to make a profit. As a second home, you would be able to claim mortgage interest and property taxes, but no other expenses.
4) Per IRS Frequently Asked Questions on Gift Taxes, "The annual exclusion applies to gifts to each donee. In other words, if you give each of your children $18,000 in 2024, the annual exclusion applies to each gift." The included table shows the annual exclusion amount applicable in the year of the gift.
5) Accumulated depreciation would be recaptured when the property was sold. This article from The Tax Adviser (an authoritative source) discusses the tax consequences on the sale of a residence after converting a rental to personal use. These factors would also apply to the sale of a second home previously used as a rental.
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