If you rent out a bedroom within your primary residence, does that time of rental count as non-qualified use for capital gains exclusion when it comes time to sell?

[kari964623]

I lived in the home for the entirety of the 5 years that I owned it.

[ThomasM125]

The rent of the room would not be considered non-qualified use for the house as a whole. However, you won't qualify for the exclusion of capital gain on the portion of the house that was rented.

[Carl]

However, you won't qualify for the exclusion of capital gain on the portion of the house that was rented.

I'm not sure that's all inclusive and accurate. If you rented the room out for the last two years you owned it, and for at least 2 years prior to that it was your primary residence, then it meets the "primary residence for 2 of last 5 years I owned it" test, and therefore qualifies for the capital gains exemption.

Please by all means, let me know and correct me if I'm wrong on that.

[Rick19744]

You should qualify for the exclusion based on your facts.

See attached link to Publication 523 and specifically look at page 11.

https://www.irs.gov/pub/irs-prior/p523--2020.pdf

Exceptions. The following situations of business or rental usage don’t affect your gain or loss calculations. • Space within the living area. If the space you used for business or rental purposes was within the living area of the home, then your usage doesn't affect your gain or loss calculations. Examples of spaces within the living area include a rented spare bedroom and attic space used as a home office. In contrast, business or rental spaces not within the living area affect your gain/loss calculations.

As long as the rented bedroom was within your primary home living area, which you indicate is true, you will qualify for the full exclusion.

However, any depreciation taken or should have been taken, will be subject to depreciation recapture at 25%.  This is Section 1250 gain.

[P Kraatz]

So I have a similar situation where I am renting out a room in my house. IRS rules are very convoluted in my opinion with this situation. So followup questions are:

1) I purchased house/land in 2007 that my family has resided in continuously as our primary residence. I began renting a bedroom in 2021 for income purposes. How do you value the asset? The bedroom is 17% of the total house square footage so I apply that to house utility expenses, etc. But is the value of the room that I put into service for rental purposes in 2021 based on the fair market value then or what it was in 2007?

2) Regarding depreciation on rental improvements like carpeting and appliances, is there a recapture tax in the future?

3) Regarding depreciation on the rental itself, can you confirm that even if you don't deduct it, there is still a recapture tax owed to IRS?

4) Can you confirm that you can still take the $500,000 capital gains reduction (for joint filers) when you sell the home of which you rented out a room for a number of years.

5) Are there any issues here affected by CA tax rules since I reside in CA.

[Carl]

1) I purchased house/land in 2007 that my family has resided in continuously as our primary residence. I began renting a bedroom in 2021 for income purposes. How do you value the asset?

You select the option for "I rent out a part of my house" along with whatever else applies on that screen.

The bedroom is 17% of the total house square footage so I apply that to house utility expenses, etc. But is the value of the room that I put into service for rental purposes in 2021 based on the fair market value then or what it was in 2007?

The program will ask you what percentage is rented out. You'll enter the percentage that is "exclusive to the renter". For example, the bedroom is exclusive to the renter. If you have a 2-bath house and one of the baths can only be access from the rented bedroom, then you can include the square footage of that bath, as it would also be exclusive to the renter. If the total percentage of floorspace that is exclusive to the renter is 17%, then that's what you enter.

2) Regarding depreciation on rental improvements like carpeting and appliances, is there a recapture tax in the future?

Yes.

3) Regarding depreciation on the rental itself, can you confirm that even if you don't deduct it, there is still a recapture tax owed to IRS?

Yes. Even if you don't take the depreciation, you are still required to recapture and pay taxes on the depreciation you "should" have taken, in the tax year you sell the property.

4) Can you confirm that you can still take the $500,000 capital gains reduction (for joint filers) when you sell the home of which you rented out a room for a number of years.

That can get tricky. Every word of the following statement matters. Every. Word.

If the part you are renting out was not rented out and therefore included as "a part of" your primary residence for at least two years (730 days) of the last five years (1826 days) you owned it, counting back from the closing date of the sale, then you would qualify for the entire exclusion amount, provided the last occupant to vacate that rented area prior to the sale was a paying tenant.

5) Are there any issues here affected by CA tax rules since I reside in CA.

I can't provide any response to this one, as I reside in FL and have never dealt with state taxes. FL does not tax personal income.

Also, percentage of floor space that is exclusive to the renter, matters for depreciation, insurance and property taxes. For utilities, you have two choices.

Choice 1.) You can use the same percentage method as you did for depreciation. But understand that in order to claim that percentage of a utility cost as a SCH E expense, the tenant must have access to it. For example, if you have cable TV and there is a cable drop in the tenant's room, then you can claim that portion of it for the renter, weather they actually use it or not. (They have access to it for their own TV. If they don't have their own TV, that's not your problem.) Otherwise, if there's no cable drop for the tenant's exclusive use, then you can't claim any part of the expense.

Choice 2) You have the option to clam that percentage of utilities based on the number of occupants. For example, if you, your wife and your child live in the property as your primary residence and you rent a room to a couple, that's a total of 5 people living in the house. You allocate 20% of your utility cost to each person. Since 2 of them are renters you can use this method to claim 40% of your utility expenses as a SCH E expense.

One special thing to note regardless of what method you use, if your home has one single land line telephone, you can't claim any of that cost on SCH E. Not a penny. Says so in IRS Publication 527 at https://www.irs.gov/pub/irs-pdf/p527.pdf on page 16 at the top of the 2nd column.

[P Kraatz]

Thanks so much for the quick, detailed and informative response. One follow up would be how to value the rented room for depreciation purposes. In 2007, we paid $850K for the house and so the room at 17% of total square footage would have a value of $144,500. But we did not start renting the room until 2021 when the house value on Zillow was $1.4M, and 17% of total value is $238,000. Which amount is appropriate to use for depreciation purposes (minus land value)?

[Carl]

Which amount is appropriate to use for depreciation purposes (minus land value)?

Since you're renting 17% of your floor space exclusively to the renter, then 17% of your original cost basis that you paid for the house is the cost basis used for depreciation.

Your cost basis is what you originally paid for the house when you purchased it back in 2007, plus the cost of any property improvements you paid for *at* *any* *time* *after* you originally purchased the house.

For depreciation, the program will figure that 17% "for you" unless you specifically and explicitly tell the program you don't want it to.

Understand that depreciation is figured on the value of the structure "ONLY", as land is never depreciated.

Regardless, when you are done, chances are what the program shows as it's final figure for depreciation will be wrong. If this happens to you then let me know. That way, I can show you how to "fix it" without an over ride so you will still be able to e-file and retain the TurboTax 100% Accuracy Guarantee.

To confirm the amount of depreciation is correct use the worksheet from IRS Publication 946 at https://www.irs.gov/pub/irs-pdf/p946.pdf  The MACRS worksheet is on page 36 and the table that applies for line 6 of that worksheet is Table A-6 on page 71.

[P Kraatz]

Awesome and thanks!