House hacking my CPA says don't claim rental income

26 Replies

I have a one family house renting out the top living in the basement. My CPA says when I file I should not file showing the rental income because if I want to sell then I will not get the 250,000 tax free allowance. I don't think I'll be selling my house.  Any thoughts or experiences on this topic would be appreciated. Thank you.

@Lawrence L. I am not an accountant and do not want to give tax advice, but I have an idea for you that could address your issue. What if you create an LLC and that LLC is a property management or rental company. Your tenant would pay the LLC, which would be a separate business from you the person and your house. This may be able to isolate the income so it is just LLC business income instead of rental income and you can still keep the tax free allowance. Just a thought.

Lawerence there are a lot of articles out that address this issue. I’m not a CPA but it’s my understanding that as long as you itemize your income/expenses and keep detailed records you can qualify for the section 121 exclusion but it will on a pro rata basis.

For example if you occupy 50% the house (based on sq footage, #of bedrooms)than you can allocate 50% of the capital gains at the time of sale towards the section 121 exclusion

- the remaining 50% will be treated as investment income and possibly subject to depreciation recapture

-this is assuming you are apportioning your mortgage interest and property taxes on the proper schedules when you file your taxes ( your CPA should be able to help you with this)

I would love to have CPA weigh in and maybe they can provide some insight as to why you might be getting that advice

@Lawrence L. You'll likely get part or all of the exclusion depending on what you do and when you sell. Did you initial occupy 100% of the property and now occupy 50%? If so how long have you rented vs fully occupying the house? Or have you been renting the top and living in the basement since the purchase? 

Section 121 eligibility is living in the property as primary residence for 2 of the last 5 years. So you can live somewhere for 2 years or longer, rent it out for 3 years or less and then sell and get the full exclusion of $250k single/$500k married on the gain. When you rent part of it that basically turns the property into a duplex for tax purposes. So when you sell you'll be eligible for the exclusion for the basement (as long as you've lived there for 2 of the last 5 years) and possibly some of the exclusion for the top (again as long as you've lived there for 2 of the last 5 years). So if at some point you decide to stop renting the top and occupy the entire house and then 2 years go by before selling you'll be eligible for the basement and part of the top. 

But I'm not a CPA, let's see if some CPAs have any thoughts @Natalie Kolodij @Linda Weygant @Michael Plaks @Alan Rohrer

Boy is there a lot of incorrect information here. 

Including what your CPA suggested- He's right in that if you report part of the home as a rental...now only your personal portion will qualify for the 121 primary home exclusion. 

However- what he's suggesting is tax fraud. Suggesting to just not report thousands of dollars of income? Jeez. 

You need to report that portion of your property as a rental. You need to take depreciation on that portion. Setting up and LLC or any thing like that wont change any thing.

Be careful with the LLC though, a single member LLC with the property will generally allow the 121 exclusion, putting your residence and rental portion in a multi member LLC, even you and a spouse, could disallow the 121 exclusion.

Updated about 3 years ago

The 121 exclusion would only apply to the personal residence portion to be clear.

@Lawrence L.

First - break away from this CPA. He is suggesting tax fraud, which means you can get into very hot water following his "suggestion."

If you don't plan to sell it, then there's no point to discuss the partial $250k exclusion and the 3-yr window that @Paul Caputo alluded to. The rest of my response is under assumption that you are not selling anytime soon.

Once you start renting, you split one property into two. For simplicity, let's assume the split is 50/50, however in reality it might be different. 

One part is your personal residence, and it is treated under the rules of personal residence. Half of mortgage interest and property taxes goes on Schedule A (if you have enough deductions to even use it). Your half of insurance, maintenance and utilities is non-deductible. When you eventually sell, half of the profit is also considered personal and is tax-free.

The other part is rental property. You must report all rental income on Schedule E. It is offset by deducting half of all expenses (mortgage interest, property taxes, insurance, maintenance etc.) and also deducting depreciation on half the house. The result can be a loss, which will reduce your overall taxes. When you sell, you will owe taxes on half of the profit, plus taxes on depreciation taken previously.

Again, trying to hide all of that, as your CPA suggested, is a no-no.

Also, the proposed LLC trick won't work.

What he is suggesting is fraud. Play by the rules. It will work out in the end. Maybe you will want another property and then you can do a 1031 exchange on the rented side and use your personal exemption on the other.

@Lawrence L. , there's some good thoughts here including first and foremost ditch the loser CPA.  They don't understand the law and evidently don't mind letting you take a fall.  No reason to add to what they've said.

But there is an interesting thought - your house is a one family house.  That would typically not result in an apportioning of space since the walls and spaces are all common and commonly used - just like house hacking with roommates.  If that's the case and you haven't set up a home business space for the rental with sq footage allocation then I think you may find that the entire structure can still be considered to be your primary residence.  There's some statutory reference that I'm too tired to pull out right now.  

So lose the cpa, declare the income and ask the new cpa about still allocating the entirety to your primary residence as long as you don't depreciated the space or take deductions for repairs etc.

The IRS will not take kindly to you not declaring income.  Money you are paid by someone in exchange for shelter is income and is declared on the Schedule E of your tax return.  I'm guessing you aren't talking to a real CPA but rather one of the retail tax preparation companies who do not have enough training to truly help you with any semi complicated return.  You need a real CPA, not a store-front, seasonal tax office.

There are ways around having turned this into rental property.  First of all, you only have to live in it for two of the past 5 years to be able to qualify for the 250k exclusion.  And if you are married, it's double ($500k exclusion).  If you rent it out for more than 3 years, you can do what is called a 1031 exchange (google this for more info) that essentially says if you sell the property, you have a short window of time where you can invest that money into a new rental and not pay taxes on the gain.  Or, you can simply hold onto it for the rest of your life.  

BTW, if your AGI is below about $37k if you are single or about $75k if you are married, you won't owe capital gains.  Keep in mind though, that if you sell the property for a profit, that amount will count towards your AGI.

If my post and the posts above don't make sense to you, please call a CPA.  If that one doesn't make sense, talk to another one.  Keep interviewing until you find one that can explain it to you.  These are beginner level tax issues for investors, and if you want to be a real estate investor, you need to understand them.  

Originally posted by @Carleen L. :

The IRS will not take kindly to you not declaring income.  Money you are paid by someone in exchange for shelter is income and is declared on the Schedule E of your tax return.  I'm guessing you aren't talking to a real CPA but rather one of the retail tax preparation companies who do not have enough training to truly help you with any semi complicated return.  You need a real CPA, not a store-front, seasonal tax office.

There are ways around having turned this into rental property.  First of all, you only have to live in it for two of the past 5 years to be able to qualify for the 250k exclusion.  And if you are married, it's double ($500k exclusion).  If you rent it out for more than 3 years, you can do what is called a 1031 exchange (google this for more info) that essentially says if you sell the property, you have a short window of time where you can invest that money into a new rental and not pay taxes on the gain.  Or, you can simply hold onto it for the rest of your life.  

BTW, if your AGI is below about $37k if you are single or about $75k if you are married, you won't owe capital gains.  Keep in mind though, that if you sell the property for a profit, that amount will count towards your AGI.

If my post and the posts above don't make sense to you, please call a CPA.  If that one doesn't make sense, talk to another one.  Keep interviewing until you find one that can explain it to you.  These are beginner level tax issues for investors, and if you want to be a real estate investor, you need to understand them.  

@Carleen unfortunately you're mentioning some broad ideas here which don't really apply to this situation. These aren't really beginner level issues- since your advice would land him smack in the middle of a tax bill. There are't ways to avoid "turning this into a rental property" If you're renting part of a propertt- that's now a rental property. 

He's not turning his primary residence into a rental- he's renting part of it while occupying part of it. 

If the house is 2,000 sq ft and the business/rental portion end sup being 1,000 then even if he occupies it for 2 years only 1/2 will qualify for the primary gain exclusion. The other half of the gain will be subject to capital gains, as well as depreciation recapture. 

He can utilize a 1031 on the rental/business half however. 

Regarding Capital gains rates being 0 at the mentioned income levels....that doesn't really work unless you sell the property for next to nothing as well. 


 

It's always best to sit down with your tax professional to go over the specifics because they can be easily misinterpreted. 

@Lawrence L.

I am not an accountant and most definitely not a CPA. I can tell you from personal experience that you do not want the IRS showing up on your doorstep with badges and subpoenas. Not declaring rental income is tax fraud.

Does your cpa suggest you report the income under “other income”? I am not a cpa, but that seems reasonable. If renting a part of your home is somewhat temporary and you do not want to treat it like a business, use schedule c and go through the hoopla of depreciating a portion of your home and maintaining the records long term, etc.

Income incurs taxes. Not reporting income is fraud. No one enjoys paying taxes, but I would imagine having a felony charge would be worse.

He still needs a CPA, not just advice from a forum. From the wording of the OP, it sounds like he needs to shop around for a new CPA. 

Lawrence, I worked for over 12 years in banking and finance, in wealth management, mortgage lending, business lending...and here's what banking and finance professionals will respond; "I'm not a CPA and not qualified to answer that.  I advise that you consult a qualified CPA." (LOL).  I think you got the idea reading the posts.  Good luck and stay profitable legally, my friend!  

I haven't asked my tax person yet, but lets say I dabbled a bit in AirBnB to see if we were up for it at our personal residence.  Where does that income go? Does it get reported with the other rental property income on Schedule E? Or does it just go under miscellaneous income on the front page? Is there a total dollar value (or number of days in service) where it switches from a little extra $ to "real" rental income, and then we need to think about what percentage of the house was used, depreciation, and the topics discussed on this thread?

Tanya,

There is a tax code exclusion where you could rent out your primary residence tax free for up to 14 days  per year. If you are under 14 days of rentals you don't have to report it.

Remember, When your tenant is filing their tax return they are indeed going to put the current address as the place from where they are filing the return. This address would be same as yours so that would draw attention.

IF the tenant is making by check (Which is normal) it would show deposits on your bank account. This is another evidence. 

MY suggestion, is play by the rules and avoid committing a fraud. I am not sure what kind of CPA would suggest committing a tax fraud.

@Ray Slack and @Tanya F. , That is going to get you into just a wee bit of trouble.  the "14 days" you're referring to is not a thresh hold under which you don't have to report income.  It is a test of whether or not you depreciate the property and offset certain expenses.  You have to declare all income!.

@Dave Foster   I don't think you are correct about this. 

Straight from the IRS' website we get Tax Topic 415, Renting Residential and Vacation Property. This tax tidbit was updated just a few days ago and says:

"There is a special rule if you use a dwelling as a home and rent it for fewer than 15 days. In this case, do not report any of the rental income and do not deduct any expenses as rental expenses."'

*** Disclaimer. I am not a CPA but I do know more about real estate Taxation than 95% of The CPAs out there.***

@Dave Foster - your 14 day rule does exist with respect to vacation property, and so does the one mentioned by @Ray Slack : tax-free rent for 14 days or less. Two different rules. 

@Tanya F. - if you truly start an AirBnB, it does not go on Schedule E like regular rentals. It is reported on Schedule C, assuming that the average stay is less than 7 days.

If it is your own home, there're important rules that will not let you take any tax loss from renting.

You might want to read this article by one of our BP experts, @Brandon Hall .

@Ray Slack and @Michael Plaks , And there it twas in the discussions on 415!  Thank you for catching me on that.  But unfortunately that seems to further deepen the dilemma of the OP doesn't it?  He has a regular renter so that's more than 14 days.  If he doesn't report the income I don't see how the affects the property as his residence.  But it does preclude him from 1031 treatment.  And it specifically would be unreported income - unless as you said Michael the accountant really meant for him to report on his Sched C and not to "not report at all".

Originally posted by @Dave Foster :

@Ray Slack and @Michael Plaks, And there it twas in the discussions on 415!  Thank you for catching me on that.  But unfortunately that seems to further deepen the dilemma of the OP doesn't it?  He has a regular renter so that's more than 14 days.  If he doesn't report the income I don't see how the affects the property as his residence.  But it does preclude him from 1031 treatment.  And it specifically would be unreported income - unless as you said Michael the accountant really meant for him to report on his Sched C and not to "not report at all".

No, this does not apply to the OP. It was in response to @Tanya F.

Thanks, guys!  I didn't mean to hijack the thread, but I thought my question might be tangentially related- only because we would be renting out part of our house (and not considering selling for quite some time, either). 

It is in fact our own house, and it won't be rented out for a little while- not until after our addition is completed. 

I wouldn't ever consider NOT reporting the income, I just don't know how I'd report it, depending on what we do.  I might rent to someone, for example, visiting the University (where I work) for a collaboration - where they'd need to stay for a month or two or three. It would not be more than a couple of months per year, we'd want the place to ourselves more than have year-round housemates. Or,... we might decide to go through AirBnB and consider only very short stays. 

My question was really whether this income gets treated differently depending on what we decide to do (how often we decide to rent) and what are the cutoff points in terms of number of days. And Schedule C vs Schedule E vs miscellaneous income. Maybe I'll start a separate thread. But I'll definitely ask my tax person first.