Rental property owners who live in a part of their rental property can take the usual tax deductions for the portion of the property they aren’t using to live in.
How do tax deductions work for an owner-occupied rental property?
The basic rule for rental property owners who live on their rental real estate is fairly simple. You prorate based on the portion you’re living in.
For example, if you’re in a duplex, you can generally treat half of your expenses paid as federal income tax deductions.
If you live in a three-bedroom home and rent out two rooms, you can generally deduct 2/3 of your expenses.
If you don’t want to try to figure out everything yourself, schedule a consultation with a tax pro.
Allocating Rental Expenses Incurred
When you allocate your operating expenses between your tenant-occupied and owner-occupied areas, you have to use a reasonable allocation. This is also known as cost segregation.
You can start out with the number of units but may need to adjust for discrepancies. For example, while duplexes are usually 50/50, if your side is 2,000 square feet and the tenant’s is 1,000 square feet, you might only be able to claim 1/3 of the expenses as a rental expense.
You generally only need to allocate expenses that are billed to the entire property, such as property taxes, insurance, and lawn care services. If you spend money on a specific rental unit, such as buying new appliances, that expense usually goes 100% to that unit.
Allocating Personal Tax Deductions
You may also need to adjust your personal tax deductions. For example, if you claim mortgage interest or property taxes on your Schedule E rental income tax form, you can’t claim those same expenses on your personal itemized deductions.
So if you’re using a 50/50 split and have $1,000 in mortgage interest, you’d usually put $500 on Schedule E and $500 as a personal tax deduction. The main idea is that you’re not double-dipping or claiming the same expense twice.
Selling Owner-Occupied Property
When you sell a rental property you were living in, you’ll also have to allocate the sale. The exclusion from capital gains taxes generally only applies to the portion of the property you were living in.
So if you had $100,000 in capital gains that would normally be excludable if you used the entire property as your primary residence, you may only be able to exclude $50,000 in capital gains assuming a 50/50 split.
What tax deductions can you take for an owner-occupied rental property?
On the personal side, you can usually only deduct mortgage interest and property taxes as itemized deductions. The only reason you’re calculating other expenses is generally for the rental business side of things.
Your rental business can deduct things like:
- Mortgage interest
- Property taxes
- Depreciation expense
- Utilities not paid by tenants
The intent of the tax law is that you get the same tax benefits as you would have if you had a separate rental property. While you can’t deduct your personal expenses, you can deduct the same expenses that real estate investors who don’t live in one of their rental units can deduct.
Reminder: Mortgage principal isn’t deductible. Even though you’re writing a check to the mortgage company, you’re building equity instead of losing money.
Is your rental income taxable?
Your rental income will generally be taxable income. If you’re a small property owner, there’s a good chance it will be passive income.
While you can claim your tax deductions, you have to report the full amount of the rent you received and enter your deductions on your tax return.
A common mistake people make is to treat rent payments as sharing expenses and not reporting anything at all. This can get you in trouble with the IRS even if you wouldn’t have owed taxes.