Author Topic: Tax Implications of Owner-Occupied 2-Flat  (Read 3402 times)

Lucky Recardito

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Tax Implications of Owner-Occupied 2-Flat
« on: September 15, 2016, 02:06:26 PM »
Hello! Long-time reader/lurker; first-time poster (having just tossed a "hello" over in the introductions thread). Not sure whether this question fits best here or in the landlording forum, so please move if necessary. Also… apologies for the length of this post. Brevity is not my strong suit.

The situation: In ~4 weeks, my SO* and I will become the owners of a 2-unit property. We'll be living in one unit and renting out the other. While we have each (individually) owned condos, neither of us has landlorded before. I've been researching the tax implications so we are prepared both in the short-term (when it comes to filing our yearly tax returns, which we plan to continue to do ourselves with the help of DIY tax software) and in the long-term (when we eventually sell). Anyone been through this who can read through my analysis below and tell me if I’ve got this right or not? I have a few specific questions that I’ve tagged throughout, but am also hoping for a general “yep, you’re right” or “nope, you’re interpreting XYZ incorrectly."


BASELINE STATS:

  • Purchase price: $815,000 (appraisal also came in at $815K)**
  • Estimated land value: $400,000
  • QUESTION 1: I’m ballparking this based on recent sales of tear-downs in the area (which range from $380-500K). Is there a better, more exact way to separate the value of the land vs. the structure? And how do I document this? The appraisal does not include this breakdown.
  • The other thought I had was to use the insurance company’s estimated building replacement cost, which they pegged at about $530K, and therefore state the land value as ~$285K… but I have more faith in my understanding of the local real estate market than the insurance company’s algorithm.
  • Estimated structure value at purchase: $415,000 (based on the estimated land value, above)
  • % of building that will be owner-occupied: 62.2%
  • % of building that will be rented: 37.8%

Other notes for context:
  • Building is a 120-year-old frame 2-flat with a pitched roof; the owner’s unit where we will live is the 2nd floor + duplexed up into the attic; because of the way the attic has been finished, the floor space up top is a bit smaller despite technically having the same footprint (so it’s not a 67/33% split, despite being 2 of the 3 above-grade floors of the building).
  • Percentages are based on square footage as reported in the appraisal.
  • I’m NOT including basement/yard/garage in those percentages — the building has a full unfinished basement that is shared on a slightly ad-hoc basis, a shared yard, and a 2-car garage in which the renters have 1 space — I figure that all sort of wraps up into the overall percentages.
  • We live in Chicago, where owner-occupied 2-flats are very common (though our duplexed-into-the-attic frame home is less common than the standard flat-roofed masonry 2-flat, in which the two units have the exact same layout and square footage).


ANNUAL TAX PREP:
My understanding is that we will need to record-keep carefully and deduct appropriate expenses that relate to our owner-occupied portion of the building from our personal taxes (62.2% of mortgage interest & 62.2% of property tax).

We will then deduct expenses associated with the rental from our “business income”:
  • 37.8% of mortgage interest
  • 37.8% of property tax
  • 37.8% of homeowners insurance
  • 37.8% utilities/services shared by the building (trash, water, and electricity for outdoor lighting and common areas — tenants will otherwise pay their own electric and gas bills)
  • 100% of maintenance costs on the rental unit
  • 100% of any management fees (should be 0, unless we hire a management company for emergency coverage when we are out of town)
  • Depreciation (this is QUESTION 2 — see below!)
  • … I’m estimating that all of this will just about equal our incoming rents, and this seems pretty common. Our net business income will be under $1-2,000/year, and thus not have a significant impact on the amount of tax we pay overall.
  • There seems to be no benefit in searching out any deductions in excess of incoming rents, as we make too much in wages (~$150K AGI, right at the limit for a married couple) to deduct additional business losses from our other income.


Okay, so depreciation is new to me. QUESTION 2: Am I doing this depreciation dance right?
This is how I understand it…
  • I start by assigning a starting value to the rental. In this case, $156,870 (37.8% of the building value at the time of purchase — NOT the land because land doesn’t depreciate).
  • I then divide by 27.5 (why? because that’s what the tax code says…) and find that I can deduct $5,704 in depreciation each year.
  • QUESTION 3: Do I stop depreciating after 27.5 years? Or do I keep right on depreciating based the 0 point? I’m guessing the former?
  • Should we make any capital improvements to the rental property (e.g. new appliances; re-do the kitchen; new flooring), we would depreciate those separately and according to their own schedules based on the type of improvement.


FUTURE TAX LIABILITY:
And now… let’s imagine it’s the future, and we’re selling this place (our current plan is to stay here indefinitely… while that’s obviously subject to change because LIFE, let’s assume that we keep the property for ~30 years). QUESTION 4: Is the breakdown below accurate?
  • Hypothetical sales price in 30 years (assuming ~2% growth annually in property prices, just for the sake of assuming something): $1,400,000
  • Hypothetical land value at sale: $725,000
  • Hypothetical building value at sale: $675,000
  • Building sale value apportioned to owner-occupied: $419,850
  • Building sale value apportioned to rental: $255,150
  • Gain on owner-occupied portion + land at the time of sale: $489,720; since this is under the $500K limit for a married couple, we would NOT owe capital gains on this portion — QUESTION 5: Is it correct to include the full land value as part of the sale of our personal residence? Or should this be prorated owner-occ/rental, and therefore  partially subject to capital gains tax?
  • Gain on rental property: $98,280
  • Total depreciation claimed: $156,870 (this assumes that we are to stop depreciating once we hit $0)
  • Capital gains tax at sale on rental property: Sale price of rental ($255.15K) - initial purchase price of rental ($156.87K) * 15% = $14,742
  • Depreciation recapture: Total depreciation claimed ($156.87K) * 25% = $39,218
  • Total (HYPOTHETICAL) tax bill at sale in the year 2046: $53,960
  • QUESTION 6: If we have capital improvements that are depreciated on shorter schedules, is there depreciation recapture on that as well? If so, does that happen at the point of sale, or directly after the improvement is depreciated to 0?


So… how’d I do?


*Yes, I know the warnings about making a major investment with someone with whom I have no legal ties -- but SO will actually become my legal husband about 3 weeks after we close on the building. The timing just worked out a little wonky.
**A totally un-Mustachian property price, I know. Face-punch me if you must, and then let’s continue the discussion.
« Last Edit: September 15, 2016, 02:14:23 PM by lalison »

brooklynguy

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Re: Tax Implications of Owner-Occupied 2-Flat
« Reply #1 on: September 15, 2016, 03:07:06 PM »
Welcome to the forum!  A few responses below -- note that I didn't address all of your questions, but only those that caught my eye.

Quote
QUESTION 1: I’m ballparking this based on recent sales of tear-downs in the area (which range from $380-500K). Is there a better, more exact way to separate the value of the land vs. the structure? And how do I document this? The appraisal does not include this breakdown.

Do your local real estate tax assessments provide a breakdown between land and building?  That's the method used for separating the cost in the example offered on page 7 of IRS Publication 527.  My own local taxing authority does not do this, and I once asked the forum the same question -- here are the responses I got, which may be helpful to you:  How to determine allocation between land and building for depreciation?

Quote
There seems to be no benefit in searching out any deductions in excess of incoming rents, as we make too much in wages (~$150K AGI, right at the limit for a married couple) to deduct additional business losses from our other income

You can carry forward losses to future years, so there could be a benefit if, in the future, you have either a net gain or sufficiently low non-passive income against which you can deduct the carried forward loss.

Quote
QUESTION 3: Do I stop depreciating after 27.5 years?

Yes.

Quote
QUESTION 5: Is it correct to include the full land value as part of the sale of our personal residence? Or should this be prorated owner-occ/rental, and therefore  partially subject to capital gains tax?

I believe the land value should be prorated.  As you noted, land value is excluded for purposes of calculating depreciation deductions (because land doesn't depreciate), but that doesn't mean you exclude it for purposes of determining gain/loss upon sale of the property.  You're generally supposed to be treating the property--including the land--as if it were bifurcated into two separate properties (the one used for personal purposes, and the one used as a rental property).

Quote
So… how’d I do?

Flying colors!  You've clearly done your homework.

Like all of my posts in the forum, this post does not constitute tax or legal advice.

Lucky Recardito

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Re: Tax Implications of Owner-Occupied 2-Flat
« Reply #2 on: September 15, 2016, 03:35:40 PM »
Thanks @brooklynguy -- super-helpful!

Quote
Quote
QUESTION 1: I’m ballparking this based on recent sales of tear-downs in the area (which range from $380-500K). Is there a better, more exact way to separate the value of the land vs. the structure? And how do I document this? The appraisal does not include this breakdown.

Do your local real estate tax assessments provide a breakdown between land and building?  That's the method used for separating the cost in the example offered on page 7 of IRS Publication 527.  My own local taxing authority does not do this, and I once asked the forum the same question -- here are the responses I got, which may be helpful to you:  How to determine allocation between land and building for depreciation?

Good idea on the tax assessment... here's how the property is assessed on the Cook County Assessor's website:
Total assessed value: $44,355
Land assessed value: $12,600
Building assessed value: $31,755
Estimated market value: $443,550

Now... I've always been confused by assessed values, because I've rarely seen them have any bearing on actual property sale prices/values. (For example, I just looked up the new-construction home next door -- it sold for $1,355,000 last year, and that new construction should have triggered a fresh tax assessment... yet it is currently assessed with an "estimated property value" of $815,330.) Now, on one hand, a low assessed value is great for property taxes... but this is so far off from the purchase price (and appraised market value) of $815K that I don't know what to do with it. THANKS, CHICAGO.

... perhaps extrapolate a percentage from it, and plop that against the actual assessed market value at the time of sale? This would suggested valuing the land at around $232K.

... Eh?


Lucky Recardito

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Re: Tax Implications of Owner-Occupied 2-Flat
« Reply #3 on: September 15, 2016, 03:42:54 PM »

Quote

... perhaps extrapolate a percentage from it, and plop that against the actual assessed market value at the time of sale? This would suggested valuing the land at around $232K.

... Eh?

D'oh -- responding to myself here because I got all wound up in the assessor's website before I dove into the IRS Publication-527. This clearly suggests that I should use the land-vs-building % in the assessor's report and extrapolate those into the price paid for the property.

Also, I'm going to pore through that 527 masterpiece tonight with a highlighter and a glass of wine because this is my favorite type of geeking out.

seattlecyclone

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Re: Tax Implications of Owner-Occupied 2-Flat
« Reply #4 on: September 17, 2016, 04:53:27 PM »
Here in Washington the assessed value is supposed to be the assessor's best estimate of the actual property value, and they usually get pretty close. That's clearly not the case in Chicago!

Lucky Recardito

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Re: Tax Implications of Owner-Occupied 2-Flat
« Reply #5 on: December 28, 2016, 02:37:27 PM »
OP here! We're now a couple months into ownership, and staring down the end of a 2016 tax year with all sorts of new awesomeness in it, so thought I'd update this thread for fun and posterity... and so folks can shout at me (kindly!) if any of my logic seems unsound.

After doing more reading of IRS materials about figuring basis on real estate, I've gotten more specific about our basis in the property. I combed through our final purchase paperwork to pick out title & settlement charges, legal fees, and recording fees -- added to the purchase price, our basis in the property overall comes to $825,347. (Yes, as previously noted -- I know that's a higher property price than frequently considered normal around here...)

Based on the division of floor space per our appraisal, we're allocating 62% of the building for our personal, owner-occupied space and 38% for the rental unit. Total basis for the rental unit is thus $313,632.

Based on the land-vs-building percentages assigned by the assessor's office, the rental unit basis breaks out as $89,094 for the land and $224,538 for the building. We'll thus claim $2041 in depreciation in 2016 (3 months) and another $2041 in depreciation in 2044 (3 months)... and $8,165 in depreciation for the 27 years in between.

We've got a bookkeeping system sorted out for rental income and expenses, and I'm feeling pretty confident about tracking that well. For 2016, our rental expenses will exceed rental income by a hair on paper (< $300); in future years, I expect we'll run a small profit (probably a couple of thousand dollars per year). I believe (from my own reading, and from brooklynguy's previous comment) that I can carry this 2016 loss forward and apply it toward a future year in which we have a paper profit on the rental.

We cannot deduct rental income losses from our other (earned wages) income because our AGI is too high (and will be for ~10 years, if all goes as planned) and this type of rental business is considered "passive" even though we, as self-managers, "actively participate."

And then, just for fun, to look hypothetically into the future... let's say that for 30 years, the property appreciates at an average of 2% per year, at which point we sell. Hypothetical sale price in 2046 is $1.4M; assuming some costs of sale, I'm taking that down to a net sale value of $1.316M (assumes 6% cost of sale). Of that, $815,020 counts toward the sale of our owner-occupied unit, leading to a profit over our original owner-occupied basis of about $304K -- upon which no income taxes are due (under $500K profit for a married couple filing jointly). However, we'll also have profited on the sale of the rental unit, to the tune of $186,448. We'll pay a 15% capital gains tax on that (just shy of $28K), and then a 25% depreciation recapture tax on the $224,538 building basis we'll have depreciated between 2016 and 2044... so that's a nice tax bill of a little over $56K. All told, we're looking at a tax bill at sale of over $84K in the far-off future of 2046. Unless there's some sort of double indemnity/tax overlap thing here that I don't understand? It seems to me that some of these dollars are effectively getting taxed twice, once as a capital gain and again as depreciation recapture...

Thanks for providing a space for me to think this out in pixels... I find this fascinating, but I can't get anyone else to geek out with me.

brooklynguy

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Re: Tax Implications of Owner-Occupied 2-Flat
« Reply #6 on: December 28, 2016, 03:31:16 PM »
Unless there's some sort of double indemnity/tax overlap thing here that I don't understand? It seems to me that some of these dollars are effectively getting taxed twice, once as a capital gain and again as depreciation recapture...

The same dollars should not be taxed twice.  The portion of the gain that is attributable to depreciation adjustments will be taxed at the lesser of 25% and the otherwise applicable ordinary income rate (and not necessarily at 25%, which is a common misconception around here), and the balance of the gain will be taxed at the capital gains rate.  Furthermore, the portion of the gain that is attributable to depreciation adjustments will depend on the portion of the gain that is allocable to the building as opposed to the land (the ratio of which will not necessarily be identical to the land-value-to-building-value ratio that was in effect at the time of purchase).  If you really want to geek out on this topic, take a spin through this thread, which explored these issues in exhaustive detail.

Of course, this analysis assumes that today's tax laws will still be in effect at the time of sale.

Quote
Thanks for providing a space for me to think this out in pixels... I find this fascinating, but I can't get anyone else to geek out with me.

Thanks for the update, and for the diversion from a slow day in the office!

***Like all of my posts in the forum, this post does not constitute tax or legal advice***

Lucky Recardito

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Re: Tax Implications of Owner-Occupied 2-Flat
« Reply #7 on: December 29, 2016, 01:25:08 PM »

The same dollars should not be taxed twice.  The portion of the gain that is attributable to depreciation adjustments will be taxed at the lesser of 25% and the otherwise applicable ordinary income rate (and not necessarily at 25%, which is a common misconception around here), and the balance of the gain will be taxed at the capital gains rate.  Furthermore, the portion of the gain that is attributable to depreciation adjustments will depend on the portion of the gain that is allocable to the building as opposed to the land (the ratio of which will not necessarily be identical to the land-value-to-building-value ratio that was in effect at the time of purchase).  If you really want to geek out on this topic, take a spin through this thread, which explored these issues in exhaustive detail.

Of course, this analysis assumes that today's tax laws will still be in effect at the time of sale.


Ah, that makes a TON of sense (in addition to pointing to a potential future tax bill that could be significantly lower than what I've currently estimated). And thank you for sharing that February thread -- I clearly have a lot more reading to do on this subject in order to truly geek out...


Aimza

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Re: Tax Implications of Owner-Occupied 2-Flat
« Reply #8 on: January 05, 2017, 09:06:33 AM »
Holy macaroni! I came here looking for the best tax software to use as I'm a first time landlord in 2016 and found all this. I certainly have a lot more to consider than I thought.

::::::::::::banging my head against the wall:::::::::::::::::::

I don't know if I'm cut out for this! Thank you for explaining everything in such detail.