Owner Occupied Property ad Depreciation

[desanto05]

Hello

I bought a two family home 13 years ago 50/50 with in-law. Over a year ago a bought out his part of ownership and refinanced to pay him his share. I started renting the other apartment in the home sometime last year. I need to know how do I calculate the depreciation? Is it based on original cost basis and closing costs and starting from the time of rental (last year) for 27.5 years or based on the refinanced amount  when I owned full ownership last year or so for the next 27.5 years?

[DaveF1006]

It depends. To clarify before I answer, what date was the buyout?  Was it in 2020 or 2019?

[Carl]

bought a two family home 13 years ago 50/50 with in-law.

So what was rented out after the two of you purchased this property? One unit? Both Units?

Did either of you live in one of the units as your primary residence during the time you owned it together?
How did you each report rental income/expenses (assuming all or part was rented out) when you both owned it? A 1065 partnership return? Or did you each report your 50% on the SCH E of your personal tax returns?

Over a year ago a bought out his part of ownership and refinanced to pay him his share.

What year would that be? 2019? 2018? "Over a year ago" only tells me that it was some year prior to 2020.

I started renting the other apartment in the home sometime last year.

What was/is the status of both units? Is the "other" unit also a rental, and has always been a rental?

I need to know how do I calculate the depreciation?

With Turbotax, *you* don't figure the depreciation. The program does that "for you", depending on how you enter the data. But how you will enter the data, depends on how the "partnership" was dealt with before you bought out the partner of this endeavor.

Is it based on original cost basis and closing costs and starting from the time of rental (last year) for 27.5 years or based on the refinanced amount when I owned full ownership last year or so for the next 27.5 years?

Again, it depends on how things were treated and reported historically, as to "exactly" how you will deal with it going forward.  Please feel free to provide a detailed history and we'll be happy to help you get this going.

Typically, the first year of dealing with rental property, or the first year of dealing with a change, can be the most challenging year. But absolute perfection in that first year is not an option. It's a must. Even the tiniest of mistakes will grow exponentially over time. Then when that mistake is caught later down the road (by you or the IRS) the cost of fixing it *will* be high.

So please, provide details of your history with this property, and I'll be happy to try and help. Also note that with the filing deadline approaching, you have absolutely no time to waste. You flat out can not afford to sacrifice accuracy for speed.

[desanto05]

late 2019 , could not rent till a few months after

[desanto05]

We bought the two family home as

co-owners 50/50 in 2006. We both lived in the same property for 13 years paying the mortgage and everything else half and half. When we file taxes every year we claimed everything down the middle 50/50. Owner occupied for both of us. In 2019 I bought his share by refinancing it based on the appraised value. As of 2019 I own the home entirely. I was able to rent the unit upstairs in April 2020 and I’m still living in the property (unit first floor (owner occupied). 

[Carl]

Got it. So nothing was a rental until you become the sole owner of the property. That actually makes things much simpler than what I was expecting.

In 2019 I bought his share by refinancing it based on the appraised value.

So basically, you did two things in one fell swoop (in a weird kinda sense).

1. You refinanced your half

2. You purchased his half.

As of 2019 I own the home entirely.

So that means that, on your 2019 tax return you got to report 100% of the mortgage interest *on the new loan only* on your tax return. You also got to deduct the financing fees on the new loan entirely. So you won't have any such fees to amortize on the new loan for the 2020 tax return.

I was able to rent the unit upstairs in April 2020 and I’m still living in the property (unit first floor (owner occupied).

There are several ways to do this. I'm going to recommend the 50/50 split manually, between your primary residence unit, and the rental unit. I'm also assuming that each unit has it's utilities metered and billed separately (water, electric, cable, etc.)

I suggest you treat the rental unit "as if" it was a physically separate unit, that includes one half of the land. Therefore you report that as a single family unit on the SCH E. You'll claim 1/2 of the mortgage interest, property taxes and property insurance on the SCH E as a rental expense. If utilities are biled separately then there is no splitting of utilities. Otherwise if utilities are not billed separately then you only claim 1/2 of the utility expenses on the SCH E.

Now understand this on splitting the utilities and property insurance.

You can only split utility expenses that are truly shared. For example, if there is only one telephone line into the property, you can not split that. (The IRS addresses hard wired telephone lines specifically in their examples.) If you have cable (TV and/or Internet) and it's not shared with the tenant, then you can't split that.

As for the property insurance, you can't deduct property insurance as a SCH A deduction. The insurance you pay for your personal residence, 2nd home or other "personal use" property is just flat out not deductible anywhere on your tax return at all. So you have to pro-rate that and can only deduct on the SCH E, that portion of the insurance that applies to the rental portion.  Another thing about property insurance too, and this is important.

If the insurance policy you have is a "homeowners policy", double check it. Typically a homeowners policy does not protect you when you are using the property for "other" than it's insured purpose. So check with your insurance agent to see if you need to purchase a separate "rental dwelling policy" for the rental portion.  This will help in several ways.

1. Your "homeowners policy" will protect your unit and your personal belongings in that unit.

2. A "rental dwelling policy" typically only protects the structure and does "not" protect the belongings of the tenant, thus making such a policy cheaper. A rental dwelling policy will include at a minimum, $300K of liability and will pay up to 80% of "lost rents" for anywhere from 6 months to 12 months, should the property become uninhabitable due to fire or other disaster.

3. As for your tenant, I always inform my tenant that they may want to buy a "renters insurance policy", which can be had for less than $200/year. Such a policy will protect the tenant's property so they're not left completely destitute should the rental dwelling they are paying rent for burns to the ground or get destroyed by other disaster, with everything they own in it.

As for the split between SCH E and SCH A, this makes your life easier if things change in the future. For example, if you mvoe out of your unit and decide to rent it out, you just add it to the SCH E as a completely new rental property. If you decide to sell one unit, it doesn't matter which one, reporting the sale is simpler. Though I doubt you'd sell only one unit, when they are arrainged in a upstairs/downstairs configuration. But you never know!

[Carl]

One more thing I forgot to mention.

Your cost basis on the unit you retained as your residence, is 1/2 of the sales price you two contracted to pay for it back in 2013.

Your cost basis on the rental unit, is the full sales price you contract to pay to the seller. Whatever percentage of the loan total that works out to be, is the same percentage of the mortgage interest that you can claim on the SCH E. The difference is a SCH A itemized deduction.

[desanto05]

Carl,

Thank you for your time and thorough explanation! I really appreciate it (specially relating to the home insurance)

This is the actual scenario:

Bought the property in 2006 for $600K. Towards third quarter 2019 had a balance of $480K, I refinanced a new mortgage inclusive of his profit share and closing costs bringing me back to $620K (current mortgage)

My land is 5000 sq feet and both units add to 3600 sg feet = 72% (I though I had to exclude the part of land right?) to depreciate. Therefore, are we saying I can depreciate half of the 72% on the original $480K or on the $620K over the 27.5 years?

[Carl]

I need another piece of information I forgot about earlier.

Bought the property in 2006 for $600K.

So the cost basis on the unit that is your primary residence is half that, or $300K. That will never change, unless there's another bubble burst in the housing market.

Towards third quarter 2019 had a balance of $480K

I refinanced a new mortgage inclusive of his profit share and closing costs bringing me back to $620K (current mortgage)

The outstanding balance on the old loan at the time of refi was $480K. Half of that is yours, or $240K.

You refinanced at $620K, I assume paying the difference of $380K to the seller for their unit you purchased from them. If that's right, then that unit is now a rental property and the cost basis on that rental is $380K. (If you took any "cash out" on the loan, then it will be less than $380K)

Now, $240K is 38.7% of the 620K loan. Therefore you can claim 38.7% of the mortgage interest as a SCH A itemized deduction, every year for the life of this loan.

Assuming there was no cash out and the remaining $380K is what you paid the seller, that $380K is 63.1% the remaining loan. Therefore, 63.1% of the mortgage interest is deductible on the SCH E every year, for the life of that loan.

If there was any cash paid to you on this loan, then the percentage of the loan that was paid to you in cash, means an equal percentage of the mortgage interest is not deductible at all. You'd have to reduce the percentage of interest claimed on the rental, as appropriate.

Take note that if you did "NOT" refi with the intent of cashing out, yet you still got say, a few thousand when all was said and done, then that doesn't count as a "cash out". You would have had to refinanced the loan with the intent of taking some cash for yourself.

[desanto05]

So the $380K was made up of his half owed to the bank $240K + $120K as profit to him and $20K in settlement/closing costs (no cash out). If my mortgage interest in 2020 was $27K you are saying that I can depreciate 61.3% = $16,470 every year for the life of loan on SCH E. When I add this plus all other expenses (half of property taxes, interest, utilities etc) I practically are at a loss (which is good but want to confirm) 

Thanks again!

[Carl]

Actually, I see I got some numbers wrong in my earlier post.  I realize now your current loan on the property that you took out in 2020 is $620K. 

So the $380K was made up of his half owed to the bank $240K + $120K as profit to him

Actually, what the seller does with the money you pay them is not "your" concern, when it comes to taxes. The fact that he used a portion of the $380K you paid them for their half, to pay off their share of the original loan, has no bearing on "your" taxes. Your concern is that of the current loan.

When you refinanced, you refinance "your" outstanding balance on the loan, which was $240K That $240K is 38.7% of the new current loan. The remaining $380K is what you paid for the rental unit. So that's the cost basis on that rental unit. The 380K you paid for that rental unit is 61.3% of the borrowed amount of $620K. Therefore you deduct 61.3% of the mortgage interest paid on that loan on the SCH E, for the life of that loan. The remaining 38.7% of the mortgage interest paid each year, is a SCH A itemized deduction.

[desanto05]

Yes - I think we're on the same page.

My only issue here had to do with the size of the property versus the land and I thought I had to calculate that to arrive at a percentage and then divide by two. In any event, what you indicate makes sense. When I take the 61.3% on the $27K interest it equals to $16,740 which I can claim on SCH E and will ultimately arrive at a loss which will bring my gross income down. The other 38.7% will be $10,452 which I will claim on my SCH A. I will continue doing this for the life of the loan right?

I think my math is correct right?

[Carl]

The 61.3%/38.7% split we figured is for mortgage interest only. It does not apply and can not be used for figuring anything else. You’ve got that done now, and can leave it in the dust.

My only issue here had to do with the size of the property versus the land and I thought I had to calculate that to arrive at a percentage and then divide by two.

For depreciation of the rental property, you only depreciate the value of the structure, as the land is not depreciated. So you have to figure what percentage of the $380K paid for the rental, gets applied to the land. In your case you first have to figure what percentage of the cost of the entire property, is applied to the land. Then apply  that percentage to what you paid for the rental property.

Start by looking at your most recent tax bill. (You should be able to find it on line at your property appraiser’s website, if you don’t have a hard copy). Take note that you can not use the monetary values on your tax bill anywhere on your tax return. We’re only using the tax bill to figure what percentage of the total tax value is applied to the land. Then we will apply those percentages to your “actual” cost basis.

So for the sole purpose of learning, I’m going to pick tax bill numbers out of thin air, and say that your tax bill shows that 30% of it’s tax value is applied to the land. We now have to use that percentage to figure how much of the $380K you paid for the rental, gets applied to the land.

So 30% of $380K (380,000 times .3) is $114,000. So in the assets/depreciation section you’ll enter the total of $380,000 in the “Cost” box, and $114,000 in the “Cost of land box”. The program (not you) will do the math to assign the difference of $266,000 to the structure, and that’s what will be depreciated over the next 27.5 years.

Finally, are the utilities (gas, water, electric, cable, etc) metered and billed separately between the two units? If they are not, then you “may” have options on this, and can therefore select the option that is most beneficial to you tax-wise.

[desanto05]

Got it!

I was just getting confused between the mortgage interest allocation and the depreciation allocation but now it's all clear!

Sorry to be a pain.. my last question if you don't mind, is;

If our total gross income is over $150K I am not allowed to take any loss towards my income correct?

Again thank you so much for the explanation and your time spending in replying

You are a true champ!

[Carl]

If our total gross income is over $150K I am not allowed to take any loss towards my income correct?

If you're married filing joint, that's correct if you add the word "other" in your comment above between the words "my" and "income". So correctly stated your question above would be "I am not allowed to take any loss from my other income. " But all is not lost! Those losses you can't take get carried forward to the next year.

Understand that it is not common for residential rental property to actually show a profit on paper at tax filing time. It's just the opposite.

Typically, when you add up the allowed deductions of Mortgage Interest, property taxes, property insurance and add that to the depreciation you're required to take each year, those four items alone almost always exceed the total rental income received for the tax year. Add to that your other allowed expenses (maintenance, repairs, etc) and you're practically guaranteed to show a loss on the rental property  every single year.

Those losses just get "carried over" to the next year, and with each passing year those losses will just continue to accumulate and grow. You can't realize those losses until the tax year you sell the property. In that tax year, those accumulated losses can be used to reduce the taxable amount of the gain  you realize on the sale, as well as reduce the taxable amount of "other" income once those losses get your taxable gain on the sale to zero.

Read my last sentence in my previous post, and let me know.