Rented out a room - working well - taxes

[TheOldestYoungMan]

This is a story about how doing things the right way yields awesome results.

When I moved back to my hometown (Houston) right after finishing school, I was shocked at how high rent had gotten.  The general tendency to go up (last I had looked at rents in the area was probably 6 years before) combined with a huge influx of Louisiana folks fleeing NO after HK resulted in rents being literally twice what I was expecting.

So I have some sympathy to folks newly arrived in town broke and needing a place to stay.  So as long as I've owned a home I rent out spare rooms for $3-$400 to young people I meet through friends/work/church.  I never really viewed this as "income" as the total amount I was getting was alot closer to splitting the utilities and such than it was to income.  Also I don't like taxes.

But it was wearing on my conscience a bit, so this year I decided to go ahead and report it.

Those of you who know about this stuff are already saying it:  Yea, you won't owe taxes on 4800/yr of rental income, you'll get a crapload of deductions.

Which is what happened.  Following all the turbotax prompts and putting in all the info on various expenses related to the house, my refund increased by $700.00.  I owed no additional tax.  I could charge twice as much rent and still not have to pay any extra taxes.

It blew my mind.  You get to deduct all kinds of stuff from the rental income.  Gas, water, electricity, insurance.  Not 100% but a % related to how much of the house is rented out.  Even a portion of the interest on the loan is used, especially helpful given that I only exceed the standard deduction every other year.  Any cleaning and maintenance type stuff, man, I am so psyched.

As for what it's like having a tenant:
1.  Rent is the easiest check you'll ever cash.  Right about the time you're ready to kick them out, they hand you a nice wad of cash.  I suspect if you don't need the money anymore, it may not be worth having them.
2.  Compatibility of lifestyle goes a long way.  Do you try to eat healthy?  Find someone like minded.  Are you asleep by 9pm every single night?  Make it clear you'll want it quiet.
3.  Why does everyone put dirty dishes in the sink?  They aren't gross while dry sitting on the counter.  I need the sink empty to wash them!  WTF!
4.  So far, it's easier for me to tolerate renting rooms to young women.  This has a huge negative impact on my dating life though.  Seems like most women can't imagine I only prefer it because they're clean and quiet.  I've heard of the "slob female roommate" but as a dude I know other dudes are super gross.  A "slob female" isn't half as bad as the average male.
5.  I rent at a very low rate to help out.  I make it clear that is why I do it when I discuss renting the room.  Usually the gratitude lasts a couple years and they're a great roommate.  Eventually they start taking it for granted, disrespecting the property, not understanding the value they are receiving, and you gotta kick em out (raising the rent sometimes does the trick of sending a "stop being a jackass" signal).

[RH]

Why not just accept cash from your tenants? Then you don't have to worry about taxes, depreciation recapture, etc...

[ncornilsen]

Cash or check, it's still income (technically.)

[I'm a red panda]

Why not just accept cash from your tenants? Then you don't have to worry about taxes, depreciation recapture, etc...

Probably because of the "not declaring income is illegal" thing.

I would check with someone who knows the tax codes well before taking many of these deductions. I believe quite a few of them may vary depending on whether the home is also for personal use (a rented room, vs rented residence) or fully rented out.  There might also be an issue about taking deductions when your rent is so far below market value.  I don't recall how it all worked.

[Mississippi Mudstache]

I'm very hazy on the intersection between real estate income and tax law, but have you considered what the effect of depreciation recapture will be when you sell the residence?

[TheOldestYoungMan]

RH:  That's how I used to think about it, but by doing the legal thing and reporting everything properly and accurately tracking my expenses I end up with more $$ at the end of the day by reporting it than by not.  The reason for this is that a certain percentage of expenses that amount to some serious change at the end of the year become at least partially deductible, which offsets a considerable portion of the rental income (in my case all of it because I'm not charging enough in rent).  If the rent you collect drops too low then some of the deduction is not allowed.

Mississippi Mudstache:  I'm also slightly fuzzy on the depreciation and how that will affect me.  I'm learning more about it in anticipation of one day having entire houses to rent out, but it seems like the worst case scenario is that at the time the property is sold, if you are able to sell it for a gain once all the basis adjustments from the depreciation are figured in, then that gain has to be treated as ordinary income, whereas it might otherwise have been treated as long term capital gains/rolled into another purchase and not taxed yet.  So it seems like in the worst case you would be paying taxes on the deductions you took eventually, but you're allowed to put it off until the sale of the property.  This might screw you if your property appreciates quite a bit, or if you forget about it and spend the proceeds of the sale, but to the extent I own it for 5 years or so I expect I'll own it until I die/am in a lower tax bracket.

So I suppose I'm looking at it like depreciation is almost like extra space in your IRA/401k !

[Mississippi Mudstache]

I suppose what would concern me is the fact that you wouldn't owe any capital gains if the home was just a personal residence at that time that it's sold. So you're potentially screwing with that tax benefit. However, if you intend to live there forever or keep the house as a rental when you move, then these concerns are not valid.

[SweetTPi]

This is really good timing- I've been thinking again of getting a roommate to share my house.  That being said, I haven't really started drilling down on the tax part.  Is there a good resource that has more than general hand waving at the issue?  I'm getting lost at the level of deductions and depreciation.  Do you have to claim depreciation, or can you not and thus avoid the adjustments and capital gains taxes later on?  What is deductible vs depreciation expenses?

I'm not even sure that question makes sense.  Oi.  This is (part of) why I've never gone forward with getting a roommate to help pay the mortgage, because I can't get a handle on how this tax stuff works.

[frugalnacho]

I was under the impression that if you rented out below market value the amount of your deductions decreased substantially or disappeared all together.  And if you rent a portion of the house you can't gain more in deductions than you earned in income from the arrangement.  What is to stop everyone from claiming they rented a bedroom out and claiming more in deductions than they "earned" giving themselves an overall net decrease in taxes between not reporting and reporting it and claiming deductions?

[TheOldestYoungMan]

There are limits.  From reading the instructions of the various forms and the various IRS publications and topics (of which there were quite a few) you run into some reductions on your deductions if the rent is far enough below "market value."  Market value for my home seemed to be on the low side of what I see around here, so even though I am renting it out super cheap, it was still close enough to market value for the deduction to be substantial.  Likewise, the total deductions are limited by the income, but up to a point you can still claim a net loss from the venture.

And yea, so, there are a ton of forms.  And I won't claim to understand them and the deeper I go the more I don't think anyone can credibly claim to understand them.

But I think this is what you're looking for from publication 925:
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Definition of passive activity loss.    Generally, your passive activity loss for the tax year is the excess of your passive activity deductions over your passive activity gross income. See Passive Activity Income and Deductions , later.

Passive Activity Loss

Generally, the passive activity loss for the tax year is not allowed. However, there is a special allowance under which some or all of your passive activity loss may be allowed. See Special $25,000 allowance , later.

A rental activity is a passive activity even if you materially participated in that activity, unless you materially participated as a real estate professional. See Real Estate Professional under Activities That Are Not Passive Activities, later. An activity is a rental activity if tangible property (real or personal) is used by customers or held for use by customers, and the gross income (or expected gross income) from the activity represents amounts paid (or to be paid) mainly for the use of the property. It does not matter whether the use is under a lease, a service contract, or some other arrangement.

Special $25,000 allowance.   If you or your spouse actively participated in a passive rental real estate activity, the amount of the passive activity loss that is disallowed is decreased and you therefore can deduct up to $25,000 of loss from the activity from your nonpassive income. This special allowance is an exception to the general rule disallowing the passive activity loss. Similarly, you can offset credits from the activity against the tax on up to $25,000 of nonpassive income after taking into account any losses allowed under this exception.
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I think I know what this means, but for all I know it applies only to beet farmers in the pacific northwest.