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Barbara
Barbara, Enrolled Agent
Category: Tax
Satisfied Customers: 1233
Experience:  16+ years of experience in tax preparation; 25+ years of experience as a real estate/corporate paralegal.
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I recently bought a 3-bedroom single family house in Northern

Customer Question

I recently bought a 3-bedroom single family house in Northern California. My intent is to live in one room and rent out the other two to cover my mortgage payment/other expenses, hold the property for a few years, and then sell the property to hopefully make a profit and take advantage of the $250k capital gain tax exclusion.

My questions are as follows:

-Do I have to report rental income/expenses for the other two rooms under this circumstance?

-Do I have to depreciate the portion of the house that I rent out?

-How would any of the above affect my ability to take the $250k capital gain tax exclusion (how would the gain/basis be then calculated?)

I would like to know how "Renting Part of Property" and "Not Rented for profit" of IRS publication 527 apply. I'm confused because some people told me that if I am intending to rent it out to "share costs" there is no tax consequences since it is an "expense sharing arrangement" -- I don't have to report any income or expenses; I don't get any tax breaks for depreciation and other costs; but I don't take a capital gain and depreciation recapture hit at the time of sale either, which would be the ideal case. I just want to keep it simple and not report income/depreciate if the rule allows.

I have some good understanding of basic individual tax. Please include any source of any relevant publication. Thanks.
Submitted: 1 year ago.
Category: Tax
Expert:  Barbara replied 1 year ago.

bkb1956 :

Thank you for allowing me to be of service to you regarding your tax question. Publication 527 is clear on "Renting Part of Property" and "Not Rented for Profit." In either scenario, you will have to report your income and expenses pertaining to the rental. In the case of "Not Rented for Profit" you will be limited to deduct your rental expenses only up to the amount of your rental income. You cannot deduct a loss or carry forward to the next year any rental expenses that are more than your rental income for the year. As to the depreciation of the property, you would depreciate that portion of the property that is rental property. When you sell the property, you would have to "recapture" your depreciation amount (i.e., decrease your basis by the depreciation amount you took or could have taken). Likewise, your $250K exclusion amount will need to be adjusted accordingly based on the percentage of rental v. personal use of the property. Please let me know if you require further information or clarification on this. Thank you.

Customer :

I think I need some clarification on the adjustment of exclusion of recapture. Here's a hypothetical example to confirm my understand.

Customer :

Purchase Price: $100,000
Cumulative Depreciation in year of sale : $25,000
Adjusted Cost basis: $75,000

Sale Price in year of sale: $400,000
Total Gain: $325,000

Capital Gain: $325,000-25,000=$300,000
Capital Gain Excluded: $250,000
Capital Gain Taxable: $50,000 @ LT capital gain rate

Depreciation Recapture: $25,000 @ marginal tax rate

Customer :

Please let me know if the above example reflects your explanation. Thanks.

bkb1956 :

Where are you getting the $25,000 to deduct from the $325,000? The cumulative depreciation in the year of sale? Depreciation taken or that should have been taken must be recaptured when the property sells.

bkb1956 :

You would also need to determine the purchase price of the land and the house. Land does not depreciate, but the house does. There are other factors that must be taken into account, i.e., that would increase/decrease your basis.

bkb1956 :

If the purchase price was $100,000, but $30,000 of it is attributed to the land, $70,000 would be your starting basis for the sale.

Customer :

The $25k was a just hypothetical number for the total amount depreciated.

bkb1956 :

I understand, but did you read my additional responses at 4:47 and 4:48?

Customer :

yes

Customer :

could you somehow tie that into my example? i think i can understand best with an example

Customer :

thank you!

bkb1956 :

Okay. Assume that the house purchase price was $70,000 ($100,000 less $30,000 for the land).

bkb1956 :

Using your example, depreciation is $20,000 so your adjusted basis (not including any other items that affect it) would be $ $50,000. Sales price in the year of sale is $200,000.

bkb1956 :

Total gain would be $150,000. Your exclusion amount would be a percentage of the $250,000 because you are renting part of the house out to others.

bkb1956 :

Please see IRS Publication 523 as it pertains to sale of your home. http://www.irs.gov/publications/p523/index.html

bkb1956 :

This IRS publication explains in detail what increases/decreases basis, the exclusion, etc.

bkb1956 :

Have you been able to view my most recent responses?

Customer :

Yes I'm still trying to understand

bkb1956 :

Do you want to take some time to review the information and come back to me with your concerns?

Customer :

So if i rent out two rooms out of three, the exclusion would be $250k*1/3 = $83k since I live in one of the rooms?

Following along your example:

Purchase Price: $100,000
Land Basis: $30,000
Building Basis: $70,000
Cumulative Depreciation in year of sale : $20,000
Adjusted Cost basis: $50,000
Sale Price in year of sale: $200,000
Total Gain: $150,000

Capital Gain: $150,000-20,000= $130,000
Capital Gain Excluded: $250,000*1/3 = $83,000 (if i live in one room and rent out two rooms)
Capital Gain Taxable: $47,000 @ capital gain rate
Depreciation Recapture: $20,000 @ marginal tax rate

let me know if this is correct

bkb1956 :

I think it would be best to figure the exclusion percentage by taking the total square footage of the house and divide it by the square footage of the rooms rented out.

Customer :

good point

Customer :

apart from that, is the logic in my calculation correct?

bkb1956 :

The capital gain/loss realized would be the capital gain amount less the exclusion amount.

bkb1956 :

Your example ends at the $47,000 for the capital gain.

bkb1956 :

You've already taken the depreciation recapture in your example.

Customer :

Capital gain realized = $130k - $83k = $47k

bkb1956 :

Correct. You've already recaptured the depreciation by decreasing your basis.

Customer :

So $47,000 @ capital tax gain is the total amount taxable

bkb1956 :

Based on your example, yes.

Customer :

OK I will think it through thanks a lot.

bkb1956 :

It's been my pleasure. Please feel free to put "for bkb1956" in the subject line if you have any additional questions. Please take a moment to rate my answer since that is an important part of being an expert on JustAnswer, and I strive for excellence. Best regards.

Customer :

So earlier you said "your exclusion amount would be a percentage of the $250,000 because you are renting part of the house out to others."

When I dug deeper, it appears that the I can take the full $250k deduction based on publication 523 under "Part of Home Used for Business or Rental" which states:
"If the part of your property used for business or to produce rental income is within your home, such as a room used as a home office for a business, you do not need to allocate gain on the sale of the property between the business part of the property and the part used as a home. In addition, you do not need to report the sale of the business or rental part on Form 4797. This is true whether or not you were entitled to claim any depreciation."

bkb1956 :

Please see the Worksheet on Page 16 from Publication 523 to see how to the exclusion is calculated. http://www.irs.gov/pub/irs-pdf/p523.pdf. What you have quoted means that you do not allocate gain on the sale of the property between the business part of the property and the part used as your home.

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Barbara
Barbara
Enrolled Agent, Paralegal
1165 Satisfied Customers
16+ years of experience in tax preparation; 25+ years of experience as a real estate/corporate paralegal.