Renting ADU on primary residence

[Wtajason]

@Carl  

I own a property with two separate mailing addresses.  I live in one building and rent out the other building.  The electric and gas utilities are metered separately, but water is shared.  I have one single mortgage for all structures on the land.  
I receive one property tax bill each year for the land and all structures on it. 

I have one property insurance policy covering both units but need to get a new one that separates the rental unit from the main unit I live in. 

 When it comes to entering my information in TurboTax, my plan is to treat the rental as a completely separate property and value the rental structure using the percentage of total square feet method.  How do I treat shared expenses like real estate taxes and mortgage interest?  
Thank you. 

[Carl]

When it comes to entering my information in TurboTax, my plan is to treat the rental as a completely separate property and value the rental structure using the percentage of total square feet method. How do I treat shared expenses like real estate taxes and mortgage interest?

To me, that's the simplest way to go for your situation. For those things that are shared (property taxes, water and the such) you'll split them using the same percentage as you will/do for floor space.  There's some important things to note about this also that makes it "very" important to pay attention to detail on each and every screen as you work it through.

I suggest you let the program do the splits for you by selecting that option when you get to it. But understand that the program can't split everything.

Keep in mind the math is not as simple as one would first think, for those things you have to figure manually. For example, if 30% of the floorspace is rental, then 30% of your water bill can be claimed as rental expense. However, if the rental did not become "active" until July 1st, then you can't claim 30% for the entire year. You'd have to add up those water bills from July thru Dec and claim 30% of that only.

 The program will split the mortgage interest and property taxes taking into account your "in service" date with no problem. It will "NOT" split the property insurance. That's because the property insurance you pay on your primary residence is not deductible anywhere on your tax return. Period.  Now you can deduct that percentage of your homeowner's insurance that applies (equal to percentage of rented floor space). However, since homeowner's insurance doesn't cover rental property, if the IRS questions this, rest assured you will lose.

Basically, so long as you don't claim anything on your taxes that would "raise flags" with the IRS, they'll not question it so long as you don't give them reason to do so. I've known folks in your specific situation where they didn't realize they needed a separate policy for the rental and had claimed part of their homeowner's insurance on SCH E. The IRS has no way of knowing they did that, and there was nothing else "questionable" on the return from the perspective of the IRS. So they basically got away with it for that year.

But where you most definitely won't get away with it, is if you file a claim on the rental unit. Not only will the insurance company not pay since the property wasn't being used for it's insured purpose, when the mortgage holder finds out (and they will because the insurance company will tell them) as far as the lender is concerned the property (or portion thereof) was uninsured and you'll be dealing with some hefty fines from the mortgage lender for having violated the terms of your lending contract.

One final thing too. Once you figure the percentage of floorspace that is exlusive to the renter, you'll allocate that same percentage of the land value to the rental also. We both know that land isn't depreciable and technically it makes no difference. However, having a zero for the value of the land is one of those "flag raisers" with the IRS, and you want to avoid that, of course.

Now pay attention as you work this through. Since you'll be selecting the option to indicate you rent a part of your home, when it gets to the expenses section you'll be asked for two types of expenses.

First, there's "whole house" expenses. The only expense you'll enter there (that I"m aware of at this time) will be the water bill. The program will do the split for you to figure the percentage of what you enter that is a rental expense. For the other utilities and expenses you'll enter a zero for the whole house expense.

You'll also be asked for "rental portion only" expenses. That would be those expenses that are exclusive to the rental only. For example, since electric is metered separately, if you pay that bill then what you pay would be entered as a "rental portion only" expense.

Whew! Confused yet? I'm not, but can only imagine how all this info is probably scrambling your brain right now. 🙂

[Wtajason]

Thanks @Carl  , I think I get everything you are saying.  At first I wasn’t going to select “I rent a part of my home” because it was a separate building on my property, but it seems like that option actually is the better one to pick in my situation. 
Under the “rental portion only” expenses, is that where I also list Maintenance/repairs done to the rental part of the property?  Would rental improvements (adding to my basis) that I want to depreciate go elsewhere?  

[Critter]

DO NOT enter the rental as part of your home as you will NOT like the consequences of the vacation home rules.  

If you enter it as it's own entity you should NEVER have the option of rental portion only if you enter it correctly.  And all improvements need to be depreciated... that is the law.  

If this is your first time setting up a rental it may be wise to upgrade to the LIVE help so you get it started correctly.  Making a mistake at this point will cost you time & effort down the road to make the corrections.  

[Carl]

because it was a separate building on my property, but it seems like that option actually is the better one to pick in my situation.

Wait a  minute! A physically separate building? Oh, I see now. I missed that in your original post. My bad!

The best way to do this both tax-wise and "work"-wise on your part, is to say that you live in a duplex and you rent out the other unit. The program gives you that option. You'll have to do "some" math manually yourself. It's still important to read the small print on every screen so that you'll know what the program will "split" for you, and what you need to figure manually.

[chucky1]

@Carl, I built and ADU in my basement so for TurboTax I am entering based on square feet that 33% of my house is 100% business. I use the 33% for all bills, land tax, etc. When figuring out a cost basis of the rental, can i, or is there any benefit to, depreciate 33% of the land value from my tax assessors statement? Thanks

[Carl]

When figuring out a cost basis of the rental, can i, or is there any benefit to, depreciate 33% of the land value from my tax assessors statement?

Land is never depreciated. I think you meant to say 33% of the structure value. You are required by law to depreciate the applicable structure value. In  your case, 33%.

If you placed this property in service in 2019, it's important to confirm the depreciation figured by the program is "in fact" correct. That's because I don't think the programmers have yet addressed a problem I've found with this.

To confirm the program did things right, use the MACRS worksheet on page 36 of IRS Publication 946 at https://www.irs.gov/pub/irs-pdf/p946.pdf

For items on that worksheet that are not readily obvious or apparent:

1 - ADS

2 - I (the letter "eye") Residential rental property

4 - 27.5 years

5 - MM/SL (Mid-Month convention/Straight Line depreciation)

6 - Use table A-6 on page 70.

All the other lines are the info you have and I don't.

The results you get should be within $5 of what the program figures.

[Carl]

I've had a few minutes to thing about this and just realized something that may be benificial.

 - You're reporting 33% of your home is rental use. That would be 33% of the value as set "before" you did the build-out/renovations to the rental portion.

 - Then enter your renovation costs as a physically separate asset. That physically separate asset is then 100% rental use and is depreciated based on 100% of it's cost. For this asset your COST would be what you paid for it, and your COST OF LAND would be zero since you didn't actually "improve" the land to increase it's value. That means 100% of your renovation costs are rental and that's what gets depreciated over 27.5 years.

Keep track of this stuff because you will need it in the future when you sell or otherwise dispose of the property.

[chucky1]

@Carl you are a wizard. Thanks for making sense out of this. Not sure if you would know, but I'm also wondering if I finish construction in 2020, therefore making the "in service date" say 2/1/2020 (when I got my final permit approved) but I spent all of the money in 2019, how does that work for my 2019 taxes? 

[Carl]

if I finish construction in 2020, therefore making the "in service date" say 2/1/2020 (when I got my final permit approved) but I spent all of the money in 2019, how does that work for my 2019 taxes?

Depreciation of those items listed in the Assets/Depreciation section starts on the date the asset is placed "in service". The in service date for rental property is basically the first day a renter "could" have moved in, which is usually the day you put the FOR RENT sign in the front yard.

If the property was not in service and "Move in ready" on or before Dec 31 of 2019, don't bother entering the property improvements on your 2019 return. The only reason to enter the assets is to depreciate them. So if the property was not move-in-ready in 2019, you have nothing to depreciate for that specific asset or assets in 2019 since the asset did not exist in a "move in ready" state in 2019.

you are a wizard

Appreciate the compliment. But it's not that hard really if you think it through. You just got to remember that when dealing with TurboTax and IRS rules and regulations, there's what I call a "generation gap" or "communications gap" between us mere mortals who are the end users, the support staff who is most knowledable in how to use the program, the programmers who write the actual computer code for the program, and the folks who write the actual IRS regulations.

-Us mere mortals are the lowest form of life.

- Support staff are those who have been taken up by the higher life forms and "enlightened". Over time, they tend to start losing touch with us mere mortals and forget their roots. Perfectly normal really.

- Programmers who write the computer code for the TurboTax program are not from here. Code writing it outsourced to another planet called Tatooine So there's a bit of a language barrier.

 - IRS regulation is outsource to another planet called Cantonica. The native language there is Gank and requires one to use a babelfish to understand it. But if the one using the babelfish is not "enlightened" as explained above, they will suffer permanent brain damage and will never be able to do a tax return wrong ever again. Therein lies the source of my illness. 🙂

[u0d4n7a0p]

Say I buy a house with an attached ADU and finance it with 1 million loan and say ADU takes 25% of sqfootage and  primary residence ( "main home" ) takes 75% of sqfootage.  Clearly debt allocated for primary home and ADU is 750K and 25) respectively. Now, when I file my taxes next year, interest too gets divided in the same ratio and all the interest paid for ADU portion would show up in schedule E  (assuming I am renting out the ADU). 

But how about debt repayment. Say, I paid off 30K of principal. Would that entire 30K gets count towards paying the debt on primary residence ("main home")?

At least that is my understanding from debt repayment rules in 1.163-8T

[Vanessa A]

Your $30,000 payment would be allocated the same as the interest is allocated 75/25. 

"Manner of allocation. In general, interest expense on a debt is allocated in the same manner as the debt to which such interest expense relates is allocated. Debt is allocated by tracing disbursements of the debt proceeds to specific expenditures" 1.163-8t

[u0d4n7a0p]

Here is copy paste from 1.163-8T

(d) Debt repayments—(1) General ordering rule. If, at the time any portion of a debt is repaid, such debt is allocated to more than one expenditure, the debt is treated for purposes of this section as repaid in the following order: (i) Amounts allocated to personal expenditures; (ii) Amounts allocated to investment expenditures and passive activity expenditures (other than passive activity expenditures described in paragraph (d)(1)(iii) of this section); (iii) Amounts allocated to passive activity expenditures in connection with a rental real estate activity with respect to which the taxpayer actively participates (within the meaning of section 469(i)); (iv) Amounts allocated to former passive activity expenditures; and

[u0d4n7a0p]

30 thosuand here is __not__ the interest amount, it is the amount which is adjusted towards the principal. 

[u0d4n7a0p]

@Carl