Tax Implications of Primary Residence vs Investment Property

5 Replies

Hi all, I own a duplex in Queens and our family both live and rent the property. My family is planning to move out of the neighborhood and rent out the entire building. 

I'm unsure whether the house will become an investment property after we move out or remain a primary residence. We've been living there for almost 3 years. I'm aware there are rules like the 2/5 rule, you have to live there for 2 years in the past 5 years for it to be considered a primary. I'm not sure if it has changed. 

Any insights on the tax implications of primary residence vs. investment would be helpful.



I owned and lived in duplexes and triplexes, in Queens, moved from one to the other, so I know what you're talking about.

For a duplex, for tax purposes, you allocated 50% to the rental, or prorate using another percentage for the rental based on a square footage. You set up the rental portion on your schedule E, depreciate it, do your income and expenses accordingly, splitting expenses, property taxes etc. This is set up as a separate asset on your schedule E.

For the owner occupied portion, you treat it differently, You don't depreciate, a lot of expenses you can write off to the rental, you can't expense for owner. For instance, I pay my landscaper, allocate 50% to rental expenses, but do not write off the personal portion. Property taxes are also allocated, with the personal portion now subject to annual limits.

When you move out of the owner occupied portion, you set up another asset on your schedule E, set up another depreciation account, and allocate the expenses to this asset, i.e. another rental. The depreciation account will start on the year you move out, a separate account, so in essence you have two separate asset accounts, depreciation accounts.

As to rules that applies when you sell, you simply have two different assets on the books, one the rental that you rented out from the get go, then another the owner occupied one that you moved from. When you sell, the owner occupied portion, you apply the rules of owner occupied properties, but there is some depreciation recapture. For the rental portion, set up as a separate asset, you pay the capital gains and recapture separately. Depending on the 2/5 rule, you may or may not pay complete capital gains on the owner portion.

There's been discussions on this board involving 1031's in these situations, and you can 1031 the rental part to another property, and sell your owner occupied portion capital gains tax free.

To play it safe, have a CPA when you're at this stage, as there are things you can overlook, trip you up, without one. I know, I didn't use a CPA for a few years, and loss more on things I overlooked than saved on fees.

Assuming all 4 of the units are the same size. 

Up to this point you shuold have been allocating 75% of expenses to schedule E as rental, 25% to schedule A as primary. 

If you've lived in it 2 years at this point and you sold tomorrow then only 25% of the gain would be tax free as a primary home under section 121. The other 75% would be taxed, or you would need to utilize a 1031 exchange to sell tax free. 

This same situation will hold true for 3 years after you sell. 

After you get out of that 2 of the last 5 year timeline- you can no longer exclude any portion as tax free on sale as your primary residence. 

I agree with @Natalie Kolodij . While I am certainly biased towards a 1031 Exchange, I think that using Section 121 to exclude up to $250k/$500k of gain is certainly better than deferring it (plus you can take cash in your pocket). Once you move out. You just need to make sure that you sell before your 2/5 years runs out. 

@Jinyu Shao , I'm a 1031 guy and have to choke when I say this - "Always take the 121 exemption every chance you get.  Tax free is is always better than deferred - even if you start right back over buying another investment property.  It's a gambling term called ratholing.  You're getting money off the table and out of harms way completely.

Secondly, although depreciation is a cool concept.  The fact that it has to get paid back upon sale eliminates most long term benefit to it (unless you do a 1031 or die holding the asset).  So if you can invest equally with equal results I'd always go the 121 route.  But you're limited to one of those every two years.  So in between you build up a rental portfolio which you alternatively 1031 and convert into primary residences once in a while to once again take advantage of at least a partial 121 exemption.

This is the greatest gig going for rei!  And in your case you get the full benefit first time in the game.  Hold that property and rent both sides for 3 more years (be careful with dates) and if it's not the best rental ever sell it and take 50% of the gain tax free (up to $250K if single or $500K if married).  And do a 1031 on the rest.  Best of both worlds!

@Jinyu Shao

It looks like you are currently "house-hacking". You have a piece of real estate that is both personal residence and investment property.

In the future, when you move out, the property will be 100% investment property.

There are tax incentives for both an investment property and a personal residence. You want to make sure you are taking advantage of the correct ones.
Furthermore, you want to make sure you are reporting your rental income.

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