Combining primary residence and investment property

[Aayer1]

My wife owns our primary residence (condo unit). I bought an adjacent condo unit as an investment property and have been renting it out since 2017.

I have been carrying forward the passive activity losses on the investment property on our tax returns.

We are considering physically combining both condos into one larger condo, as we feel the market value of the larger condo would be higher than the sum of the individual condos. I would still keep renting out the two bedrooms of the condo I purchased in 2017.

What would be the tax implications of combining the two condo units? The combined condo unit would be part primary residence and part investment property, thus the confusion.

thanks!

[Critter]

This is not a simple question that can be answered properly in this public forum ... I highly recommend you sit down with a local tax professional to discuss all the implications this will have before you do something so you can make an informed decision. 

Also a discussion with the condo board to see if what you want to do would be permitted, a real estate professional to see if this makes sense in that regard  and  a contractor to see if it can even be done and at what price. 

[Hal_Al]

Combining the units makes the new larger unit you residence.  Your renting out the bedrooms makes it a roommate situation, not a true rental.

If this is merely a cost sharing arrangement where the amount paid is below fair market rental, there would be no reportable income to you. If the “rent” amount is fair market value, or more, there is still some question as to whether you even have to report it, as it almost always comes out zero. Most people take the attitude that it is not income; it's just room mates sharing expenses and ignore it. Family, as opposed to unrelated roommates, makes that position stronger.

Here’s what you may be required to do:

Report the income (enter at Rents & Royalties/Income & expenses from Rental Properties); and then deduct the expenses on schedule E. If the room mate has full run of the house, and there's just the 2 of you, then half your expenses are deductible (mortgage interest, property taxes, insurance, utilities, repairs, and depreciation [if needed}). Your net income will usually be less than zero.

What you are NOT allowed to do, because it is your own home (you have "personal use") is claim a loss from this activity, to offset other income. Because of the "personal use rule", your deductions are limited to your income. Net effect ZERO.

It is possible for you to gain a positive tax effect from this activity; If enough of your schedule A deductions (mortgage interest &  property tax) are shifted to Schedule E, and your standard deduction becomes bigger than your itemized deductions, you will have effectively saved on taxes.

If you have no mortgage, then there could well be profit involved, which you may have to offset with depreciation that could lead to "recapture" in the future when the property is sold.

The carried forward losses would remain suspended until the unit was sold. Then they could be claimed  on your tax return.

[Carl]

As it stands now, you own to physically separate properties. One is your personal residence. The other is a rental reported on SCH E as a part of your personal 1040 tax return. Each property has a physically separate mortgate and receives a physically separate property tax bill each year. Each property also has it's own physically separate insurance policy with one policy being a "residential policy" and the other being a "rental dwelling policy". Each property also has all utilities (gas, water, electric, cable, etc) metered and billed separately.  Finally, each property has it's one physically separate postal address. 

So are you talking about knocking out a wall that currently separates the two units? If so, you're not to the point of concerning yourself with tax implications yet.

 - Since what you "own" in a condo is considered to be from the back of the sheetrock on the walls and ceiling, and from the bottom of the flooring (be it carpet, tile, vinyl or whatever) towards the inside of the space, you can't just do what you want with this. *you* don't own the wall structure between the two units and taking out a wall may impact the structural integrity of the building affecting other condo owners in the unit on both sides, behind you, and above/below you if a multi-story structure.  So first you need permission from the condo board (or owner if there's no board) as well as a permit from whatever entity issues building permits. So until you have permissions from the owner of the structure (which is not you, rest assured) and know "for a fact" you will actually get a building permit, there's really no need in pursuing the tax issues.

Keep in mind that getting the permit requires coordination with the postal services, utilities, mortgage lender(s), and a slew of other agencies that I can't think of now.

In other words, the taxes are the easy part. Getting to that point is not.

[Aayer1]

Carl:

thanks for your response. We have gotten permission from the developer, who would

actually be performing the construction for us. All permits, etc. have been vetted. That is why I was jumping to my tax questions (which I am still unclear about).

We would be knocking down two walls but will put up barn doors to have some separation between the units. The tenants in the current investment property are family members, who do not mind the walls coming down.

Simply put, would I be able to keep my current schedule A (current primary residence)  and schedule E (investment property) if the units were combined? If so, would I need to keep two sets of appliances, etc.?