6 Tips for Maximizing ADU or Rental Property Tax Deductions

Rental Property Tax Deductions Require Separate Spaces

Whether you’re thinking about renting out a portion of your home or building and renting out an ADU, you must have a full division between your space and your tenant’s to claim rental property tax deductions, according to Evan Liddiard, CPA, director of federal taxation at the National Association of REALTORS®. If the tenant uses the rented space exclusively, you can allocate the expenses — including depreciation, utilities, and property taxes — between the rental and nonrental areas in the house.

Here’s how it works. “You can’t spend time in the same space as your tenant and call it a rental unit,” Liddiard explains. “In other words, if someone moves into a room in your house and shares your kitchen, you have a roommate or a guest as opposed to a tenant. On the other hand, if the tenant moves into your basement, where there is a kitchen and bathroom, and you leave them alone and they leave you alone, you can apportion your home between the rental and nonrental portions. That is important for tax purposes: The rental unit must be used exclusively by the renter and not by the owner.”

An Airbnb Produces Short-Term Rental Income

What about something that might require less commitment, like an Airbnb? The tax considerations for long-term rental of space in a home and Airbnb rental are different, says Shri Ganeshram, founder and CEO of San Francisco-based Awning, which helps customers buy and manage short-term and long-term rentals. “Long-term rental income is subject to federal and state taxes, while Airbnb rental income is considered short-term rental income and may be subject to state and local taxes,” he says. In choosing which way to go, “the homeowner should be aware of the tax implications of both types of rental income.”’

Get Tax Help for Owner-Occupied Rental Property

Experts recommend homeowners assess the financial pros and cons from a tax perspective before moving ahead with an owner-occupied rental.

“It wouldn’t be a bad idea to consult a lawyer, and it would certainly be smart to consult a tax adviser, so you know how to treat any income and expenses on your tax return,” Liddiard says. The only possible exception would be if the potential landlord “really knows their way around taxes,” he adds.

For instance, if a homeowner wanted to enclose a stairway to forge a division between their home and the rental property, they should seek the guidance of a tax adviser, Liddiard says. They could hire a lawyer to consult about risks and aspects of the lease agreement and the tax adviser about how to treat income and expenses on tax returns.

Rental Property Depreciation Deduction for Wear and Tear

Homeowners who want to rent parts of their homes often wonder whether they can get tax relief to offset wear and tear on the rented portion. “That’s where the depreciation deduction would come in,” Liddiard says. You start with the cost of the house, not counting the land, allocate between the rental portion and the nonrental portion, and you can depreciate the rental portion over 27 and a half years.”

Liddiard offers a hypothetical example: A homeowner might pay $250,000 for a house, with the land portion worth $50,000. Because land isn’t depreciable, $200,000 is considered depreciable assets before the allocation between the homeowner’s portion and the renter’s portion.

Assuming the basement is the rental unit, and it comprises half of the home’s total square footage, $100,000 is allocated for the rental. That $100,000 would be divided by 27.5 years. That’s the amount deductible as depreciation on the rental property if it had been rented or offered for rent for the full year from Jan. 1 through Dec. 31.

Be Aware of Capital Gains

“The catch is, when you sell the house, the amount you’ve taken in depreciation will lower your basis and increase your gain,” Liddiard says. “You will have to pay taxes on that gain when and if you sell the property. This is because the cost basis of your home has gone down with that depreciation over time. As a result, you have more profit, and that portion of profit allocated to the rental unit will be taxed.”

Keep Detailed Records of Rental Income and Expenses

If you pursue an owner-occupied rental, you’ll need to keep exact and detailed records of all rental income and expenses. That will help you accurately report your rental income on your tax returns and support any deductions you take for expenses.

Those records may include rental agreements, receipts for expenses, a log of the number of days the space was rented, and a record of all rental payments received, says Nathan Clare, founder of Buying Jax Homes in Jacksonville, Fla. “Additionally, the homeowner should keep track of any improvements made to the rental space, as these may be deductible,” he adds. Proper recordkeeping will help the homeowner comply with tax laws and can support their tax filings if audited by the IRS, Clare explains.

Rental income, whether from renting out part of your home or an ADU, can help you manage mortgage and maintenance costs. A good first step is understanding the tax requirements and consulting experts as needed so that you’ll make the right decisions.

This article provides general information about tax laws and consequences, but shouldn’t be relied upon as tax or legal advice applicable to particular transactions or circumstances. Consult a tax professional for such advice.

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