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squirrellandlord
Level 2

When renting out a room, is depreciation still subject to recapture? What about capital gains?

We converted our basement to an in-law suite and are renting it out to a tenant. The utilities are shared; it is not a duplex or legally separate unit. It appears (from pub 527) that we are able to claim depreciation on the building value of that portion of the house, as well as the money we spent converting the basement. Consequently, I understand (from pub 523) that we may need to pay back "some or all of [this] depreciation" at such time as we sell the house in the future.

 

Pub 523 states that "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." This would suggest that we would not be subject to capital gains tax on the first $500K of capital gains, despite the business use (renting).

 

Does a similar exemption apply to depreciation recapture? I don't want to be stuck with a huge tax bill if we move house in a few years' time.

6 Replies
AmeliesUncle
Level 12

When renting out a room, is depreciation still subject to recapture? What about capital gains?

 

 

Any gain due to depreciation will still be taxed.  The $250,000/$500,000 exclusion does not cover that.

 


@squirrellandlord wrote:

We converted our basement to an in-law suite and are renting it out to a tenant.

 

Pub 523 states that "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."

 


If the basement is it's own "dwelling unit" (for example, its own kitchen, entrance, etc.), that is treated as a separate property and would not be covered by the $250,000/$500,000 exclusion.  

Carl
Level 15

When renting out a room, is depreciation still subject to recapture? What about capital gains?

It appears (from pub 527) that we are able to claim depreciation on the building value of that portion of the house,

Actually, you're required to depreciate, based on the percentage of space that is "exclusive to the renter".

as well as the money we spent converting the basement.

More than likely those costs are property improvements. Here's where percentages can come into play.Let's talk about the basic structure and land first. Then I'll get into the other stuff.

If 20% of your total floor space is exclusive to the renter, then you're required to depreciate 20% of the total structure value.  Now you'll include in your assets/depreciation section say, 20% of your land. But the value of the land won't be depreciated anyway since land is not depreciable.

Let's keep the numbers and the math simple for this example, and say you paid $100,000 for the entire property, with 30% of that cost allocated to the land.  Then say you're renting out 25% of your floor space exclusive to the renter.

Twenty five percent of $100,000 is $25,000. But we have to allocate 30% of that $25,000 to the land. So when entering this in the program, you'll enter $25,000 in the "Cost" box and $7,500 in the "cost of land" box. ($7,500 is 30% of $25,000)  That means a structure value of $17,500 ($25,000 minus $7,500) will be depreciated over the next 27.5 years.

That takes care of that. Now lets cover your cost incurred in the process of making it a rental and getting it move-in ready for a tenant. For this example, we'll say you spent $10,000 for a new floor, finishing out the walls and ceilings and installing a kitchenette and maybe a bathroom for that tenant. Since all the work was done in the rental portion and for the primary purpose of making it a separately rentalable unit, it can all be grouped together as a single property improvement. Additionally, since this work was done 100% for the rental portion, it's 100% business use. (unlike the initial entry for the entire house which is 25% business use.)

 

So the cost of your property improvments would be entered as such declaring 100% business use. Now you improved the property - *not* the land. So you would still classify this improvement as "residental Rental Real Estate" with 100% business use. In the COST box enter $10,000 and in the "cost of land" box, enter a zero. The entire amount of $10,000 will be depreciated over the next 27.5 years.

 

Now take special note since you have two asset entries for this property that are "NOT" the same percentage of business use, it will be up to you (and you alone) to keep track of your total cumulative depreciation as the years pass. That's because when you sell the property you'll be required to recapture all depreciation taken and pay taxes on it in the tax year you sell.

With the type of setup I've "exampled" here it will be easier to report the sale of your house (when that day comes) in the "sale of business property" section, than it will be elsewhere in the program. You'll also be able to get a partial credit for the "lived in 2 of last 5 years" too, if you qualify.

squirrellandlord
Level 2

When renting out a room, is depreciation still subject to recapture? What about capital gains?

Thanks for all this detail, @Carl!

 

Reposting my response to @AmeliesUncle below, since it was erroneously flagged as spam.

 

Any gain due to depreciation will still be taxed.  The $250,000/$500,000 exclusion does not cover that.

Thanks, this is a really helpful clarification. And as I understand it, this tax applies regardless of whether we actually deducted the depreciation.

 

It also appears that the rate applied to depreciation recapture is typically 25%, which would be higher than the marginal rate we would pay now if we were not to deduct depreciation. Is that correct? It seems surprising that the net effect of claiming depreciation could be to pay more in taxes overall.

 

 

If the basement is it's own "dwelling unit" (for example, its own kitchen, entrance, etc.), that is treated as a separate property and would not be covered by the $250,000/$500,000 exclusion.  


How can I learn more about this? In pub 523, under Business or Rental Use of Home, "space within the living area" is defined without reference to "dwelling units". Instead, it gives some examples:

"Examples of spaces within the living area include a rented spare bedroom […]. Examples of space not within the living area include a […] rented apartment in a duplex".

 

If it's the case that:
i) We must ultimately pay a (somewhat) higher tax rate on the depreciation, which we are effectively required to take; and

ii) We must pay capital gains tax on ~25% of our house (the basement), as a result of having rented it out; and

iii) We cannot apply a loss from the rental 'business' (which I foresee, since the apportioned mortgage interest and depreciation could exceed our rental income, esp. with covid) to our personal taxes, such that our personal taxes also go up (vs. applying 100% of the mortgage interest and property tax deductions to our personal taxes); and

iv) Our taxes also get considerably more complicated

then renting out the basement becomes really quite unappetizing…!

Anonymous
Not applicable

When renting out a room, is depreciation still subject to recapture? What about capital gains?

in addition, if you are renting out to a relative at less than FMV your deductions will be limited to rental income. 

money spent converting would not be a deductible expense but a capital one subject to depreciation,

when you take depreciation on your home whether for home office or because a part was rented, depreciation recapture comes into play. 

AmeliesUncle
Level 12

When renting out a room, is depreciation still subject to recapture? What about capital gains?


@squirrellandlord wrote:

It also appears that the rate applied to depreciation recapture is typically 25%, which would be higher than the marginal rate we would pay now if we were not to deduct depreciation. Is that correct?


No.  It is taxed at your regular tax rate, UP TO 25%.

 

 


@squirrellandlord wrote:

 

 How can I learn more about this? In pub 523, under Business or Rental Use of Home, "space within the living area" is defined without reference to "dwelling units". Instead, it gives some examples:

"Examples of spaces within the living area include a rented spare bedroom […]. Examples of space not within the living area include a […] rented apartment in a duplex".


There isn't any one clear and easy-to-read spot to read about it.  But as the examples show, if it is PART of your home (your living area), then the exclusion applies.  If it is a completetly separate "dwelling unit" (a separate apartment), then the exclusion does not apply to that.  Think of an apartment building with many "units".  Each is a separate living quarters with their own entrances, kitchens, etc..   Just because they share the same building does not mean they are all considered as one 'home'. 

 

 

 


@squirrellandlord wrote:

If it's the case that:

ii) We must pay capital gains tax on ~25% of our house (the basement), as a result of having rented it out; and

iii) We cannot apply a loss from the rental 'business' (which I foresee, since the apportioned mortgage interest and depreciation could exceed our rental income, esp. with covid) to our personal taxes, such that our personal taxes also go up (vs. applying 100% of the mortgage interest and property tax deductions to our personal taxes); and

 


No.  If it is a separate "dwelling unit", then you are allowed to take any applicable losses, IF they are allowed with the Passive Loss Rules (and if the Passive Loss Rules do restrict it, the loss will be carried forward until they can be eventually be used, which includes when the house is sold).

Carl
Level 15

When renting out a room, is depreciation still subject to recapture? What about capital gains?

Basically what he's saying is that you can treat the property as a duplex where you live in one unit, and rent out the other unit.

Or you can treat and report it as it's own physically separate rental property.

For the latter, you would allocate a percentage of your cost basis to that unit. Then report everything concerning that unit at 100% business use "as if" it was a physically separate piece of property. One area that can be problematic for some with this scenario, is if the utility costs are not metered separately between your living space or unit, and the rental living space or unit. Here's what I mean.

Your property taxes and mortgage interest deductions on the SCH E are limited to the percentage of the property that is exclusive to the rental. You can also only deduct on the SCH E that percentage of your homeowner's insurance equal to the percentage of rental space.

While the percentage of Mortgage interest and property taxes that do not apply to the rental portion are a SCH A itemized deduction, you have to prorate the insurance for the rental portion. What you pay for property insurance for the percentage of space that is not rental, is flat out not deductible anywhere on any tax return.

Then there's the utilities. How you split the utilities is not based on the percentage of floorspace. It's based on the total number of inhabitants that live in the house. So if you, your wife and two kids live in your "personal use" section and you rent the rental portion to a single renter, that's a total of 5 people. Therefore only 20% (one fifth) of your utility expenses are deducted as a rental expense on the SCH E..... and only for those utilities that are truly shared with the tenant.  Then to further complicate this, if you only have one landline telephone in the entire property, not one penny of your phone bill is deductible as a rental expense - even if that line is "shared" with the tenant.

For other utilities, (gas, water, electric, cable, internet) they must be shared with and accessible to the renter for you to claim any percentage of those expenses on SCH E. That doesn't mean the tenant has to actually use them. It means they must be "accessible by and available to" to the tenant. Here's an example:

The rental portion of your property that is "exclusive to the renter" does not include a laundry room. So you and the tenant share the same laundry room washer and dryer. That laundry room can not be included in the percentage of space that you claim as a rental, since it's not "exclusive" to the renter. But using my numbers above, 1/5 (20%) of your water and electric bill is a deductible expense on your SCH E.

So it is for these reasons pointed out above, that you want to ensure things like this are covered in  your rental agreement with a tenant. That way if ever questioned by the IRS or audited on your SCH E expenses, you have something "in writing" to show your right to claim that rental expense.

On a side note just to cover yet "another base", if you are renting to a single person and they have a child, note that in the rental contract that the child (or other dependent) is "in fact" living in that space. If this were the case with my scenario above, that would be you have a total of six people living in the structure with two of them being tenants. That means you can claim 33% (one third) of your utility expenses on the SCH E.

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