I purchased a house to be used as a second home in the beginning of 2005 and have my parents used it until May 2006. In June 2006 I converted it to a rental property and got a tenant in July. Around the same time I listed the property for sale and in mid-October I closed on the sale. The prices of the houses in NJ went down a lot from 2005 to 2006. Calculating the adjusted cost basis on the purchased and sale, i now have 35K losses . Here are my questions:
1) The fact that i have used the property as a rental property for 3.5 months, will i be entitled to all expenses associated with the rental property including depreciation, maintenance & repairs?
2) I owned the property for 22.5 months, of which 19 months as second home and the last 3.5 months as rental/investment property. Can i claim my huge loss on the sale of property ? WHich form should i use - form 4797 (Sale of Business Property) or Schedule D? I think if use schedule D, i won't be able to deduct the loss unless i have capital gains to offset which i don't. Is this a red flag to IRS that will increase the chances of me getting audited?

Thanks in advance for your help.

you would use form 4797 to begin with, and that will carry you to schedule D. Any loss allowable will be capital, not ordinary, as the rental house was a capital asset, and you will recapture any depreciation taken as income. The question of depreciation taken is a good one because they say you can't take any if you acquire and sell the property in the same year, and your acquisition date is the date you placed the house in service for rental purposes.
section 1250 property shows up under sectiuon III of 4797. Any loss allowable will be short term because you only used it as rental property for less than a year. Your previous holding period don't count. You can deduct costs directly associated with the property as a rental, although you can take expenses incurred as a second home on schedule A. The expenses incurred that are directly associated with it being a rental would be taken on schedule E, profit or loss from the rental. So, you'll end up using 4797, sch D., Sch E, along with your 1040. You have to use E because you have to show what happened during those 4 months. This is a bit complicated, I know. If you do it right, I can't see why it would be a red flag. The problem is that it's a capital loss,(3,000) and you'll have to carry it forward rather than taking all of it in one year. There is no 1231 property to take an ordinary loss against. if anyone can shed more light, please do so.