Renting out rooms in primary residence - Depreciation and capital tax consequence?

Question

I just bought a single family home. My intent was to live in it and rent out a couple of rooms and then sell the property in 2 years in order to take advantage of the $250k capital tax exemption. My understanding of the tax rule is I need to report the rental income and expenses on Form E for the portion of the house that is rented out. My questions are:

1. Does reporting rental income/expense on Form E have an impact on the capital tax $250k exemption if I rent the house out?
2. Can I depreciate the portion of the house that is rented out?

Thanks.

1. Does reporting rental income/expense on Form E have an impact on the capital tax $250k exemption if I rent the house out? 2. Can I depreciate the portion of the house that is rented out?

Thanks.

Bill Exeter · Answer

Hi Jimmy,

Depreciation recapture would be taxable upon sale (unless you do a 1031 Exchange on the portion that you rented out). Depreciation recapture is not excluded under Section 121 (the $250,000 tax free exclusion).

You can take the entire 121 Exclusion up to the $250,000 since it is a SFR on your capital gain.

Jimmy Chim · Answer

@Steven Hamilton

Thanks for your response, Steven. That is very helpful. I do want to follow up if that's alright. Let's say for tax purposes, I'm renting out 30% of my home. My understanding is that under this situation I will depreciate 30% of the building basis over 27.5 years and deduct 30% of the expenses (utilities/repair expense etc that would otherwise be non-deductible if I'm not renting out) in schedule E.

My question is: What happens when I sell the house at some point in the future after I met the 2 out of 5 year rule and realize a capital gain? Is my capital tax exclusion going to be only $250*70% = $175k? How would I be taxed for portion that I depreciated (depreciation recapture)?

Any insight would be helpful. THanks!

Steven Hamilton II · Answer

Jimmy Chim,

You will have to report the income and expense. In fact it is in your benefit to do so because it can help you qualify for more.

You are required to depreciate that portion of the home. You will have to recapture the depreciation whether you take it or not.

-Steven

Renting out rooms in primary residence - Depreciation and capital tax consequence?

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