Should we sell or rent our owner-occupied duplex? Do we lose our "primary residence" tax benefit if we rent the entire duplex before selling?

[dave10]

My wife and I are planning on moving out-of-state later this year and I'm trying to do some tax planning beforehand.  We have a duplex--live in one side and rent out the other.  When we move, we are considering two options: sell the duplex, or keep the duplex for now, rent out both sides and sell it next year.  Using TurboTax, we have been deducting 50% of the duplex on our taxes.  If we decide to sell right away, I think the tax implications are pretty straightforward. 

But I can't get clear on how we will handle the situation if we keep the duplex, rent out both sides, and sell it next year.  Right now moving, renting out both sides, and selling later is our preferred choice.

Do we need to convert our 50% of the duplex from personal to business use?  If so, how would we do that in TurboTax?

If we do that, would we still be able to exclude 50% of the capital gain on the sale (since we will have lived in the duplex as our primary residence for at least 24 of the last 60 months)?  What if it ends up selling at a loss? Do we exclude 50% of the loss, also?  We did some major renovations and I am not certain that we will sell at a gain if we include the cost of those renovations.

Honestly, I'm not sure I am even asking the right questions.  I guess I'm trying to figure out if there are tax pitfalls to keeping the duplex, renting out both sides, and then selling next year rather than just selling outright.  Does it matter one way or the other tax-wise?

[LudwigVan_fan]

I'll admit up front, it has been quite some time since I looked at the rules for sale of personal residence.  

Having said that, there may be some exemptions I'm missing.  But, if you move out, live in another place as your principal residence, and rent out the other side; unless there is some exception, I would presume when you sell it, it would no longer be considered a sale of your principal residence.

I'm not sure of the result if you just left your side empty, pending the sale.  Without further research, that to me would be a stronger case of selling a principal residence, then if it was converted to rental and actually rented out, depreciation claimed, etc.  

That's why I'm putting this as a comment, and not an answer.  Hopefully someone with more expertise in this area will answer.

[dave10]

Thanks so much pezlud, we have been considering the scenario your suggest, too -- just leaving our side empty.  That probably would make a stronger case when we sell later.  But, then we thought, why not rent it for the year and benefit from the income?  As long as this does not undermine or outweigh the tax benefit to selling as our "primary residence".  Just feels like such a tangled issue!

[LudwigVan_fan]

I would have a more definitive answer for you if I was more current on the issue.

Try reading through Publication 523 from IRS.

<a rel="nofollow" target="_blank" href="https://www.irs.gov/publications/p523/ar02.html">https://www.irs.gov/publications/p523/ar02.html</a>

[LudwigVan_fan]

I did not read this in its entirety, but these catches my eye....however, you should read the whole document carefully

Determine whether the business or rental space still counts as a business space.   A space formerly used for business is considered residence space if ALL of the following are true:

    1.  You weren’t using the space for business or rental at the time you sold the property,

    2.  You didn’t earn any business or rental income from the space in the year you sold your home, and

    3.  You used the space as residence space for 2 years out of the 5 years leading up to the sale.

  If all of these are true, your business usage DOESN’T affect your gain/loss calculations.

If when you sell the property, it is being rented, that would disqualify statement 1.  

If when you sell it and you were renting it in the year you sell it, #2 would also be no.

Thus, the only one meeting this particular test would be 3.

However, there may be other exceptions that I didn't read.  Good luck

[dave10]

Great information!  Thanks!  I skimmed over the publication, including the section you highlight above.  Right before that section, it says:

1)

"Determine whether the space used for business during the 5 years before the sale is considered to be within your home or not.    If the business or rental space was physically part of the living area of your home, such as a spare room used as a bed-and-breakfast bedroom or attic space used as a home office, your business usage doesn’t affect your gain/loss calculations."

2)

"If the business or rental space wasn’t within your living space,   such as a first-floor store with residence, an apartment with its own entrance (and kitchen and bath), or a working farm with a farmhouse on the property, continue to Determine whether the business or rental space still counts as a business space , next."

This is so tough, because the rental space IS our living space (not just one part of it).  So in that sense wouldn't it fall under the first case, even though it is its own apartment that has its own entrance/kitchen/bath/etc?   The space used for business (i.e., rental income) is fully within our home.

But if we fall under the second statement, then it sounds like we would most certainly be taxed at capital gain/loss.  

But I kind of think the first statement might apply, in which case the publication says "business usage doesn’t affect your gain/loss calculations"

[view2]

1.(a) Exclusion

Gross income shall not include gain from the sale or exchange of property if, during the 5-year period ending on the date of the sale or exchange, such property has been owned and used by the taxpayer as the taxpayer’s principal residence for periods aggregating 2 years or more.[only half of your sale proceeds will be a 121 exclusion]

https://www.law.cornell.edu/uscode/text/26/121

2.When you live in half of the property and rent out the other half, the IRS treats the duplex as two separate properties. It requires you to allocate costs between the two halves, so you will claim half of your mortgage interest as a deduction on your Schedule A while you claim the other half as a rental property expense on Schedule E.Since your duplex gets treated as two properties, only half of your sale proceeds will be subject to taxes.[depreciation is recapture at a rate of 25% ]

3.When you change property you held for personal use to rental use (for example, you rent your former home), the basis for depreciation will be the lesser of fair market value or adjusted basis on the date of conversion. [i.e. personal losses are not allowed]

Property Changed to Rental Use 

https://www.irs.gov/publications/p527/ch04.html#en_US_2016_publink1000219148

4.What is a simple entry in Turbotax becomes rather complex when the taxable classification is changed.

It will be easier in the future to do  the allocation  to personal and rental now and enter the duplex as two separate properties with the correctly calculated basis for each.

[dave10]

Thank you; this is very helpful information.  If I am understanding correctly, you are suggesting that it would be easier to deal with this issue now by entering the duplex as two separate properties?  Right now I've been letting TurboTax handle it as one property and it figures out the 50% expenses, deductions, etc.  TurboTax has been doing this for the past several years for us.

So during 2016, we lived in one half and rented out the other for the entire year.  During 2017, we will live in one half until October and then convert our half into a rental.

If it is going to be easier to deal with this in the future by splitting the duplex into two properties, can I make this change in TurboTax for our 2016 taxes without utterly confusing it?  How would I do that?

Also, if TurboTax views the duplex as two properties and we eventually sell the property, how will we enter the sale?  We will be selling just one property, not two.  So I'm not sure how that would work.

[view2]

The 50% allocation is between a rental Schedule E  and personal deduction Schedule A for taxes and interest, not between two rental properties.[you will have to calculate the allocate of interest,property taxes and insurance to each when they both become rental units]

You can wait until 2017 to change , I misread the conversion as in 2016.

You will not confuse the program.

Generally unless you are really fortunate  both units are not always rented at the same time and the same number of days.

Proceeds  and selling expenses are allocated 50% to each a rental rental and personal side that will still be in 121 exclusion time frame when sold.

Personally break down quadplex to single dwelling for tax reporting and do any allocation before hand to enter into Turbotax.

When you have the desktop you can save your tax return with a unit test name and do a run through before the taxes are due next year.