Capital Gains Tax Exemption While Renting Basement

[rjschwar]

What is the name of your state (only U.S. law)? WA

We are planning to sell our house for a significant gain. We purchased in 2009 for 380k and are planning to sell it for around 850k with the potential for it to go for up to 950k. We also rented our basement out for the last 4 years ending January 1st of this year which has a kitchen and bathroom and two bedrooms (about 1/3 of our sq. footage). There is also an unfinished portion of the basement that is shared space. We have a door from our kitchen to the basement, and the back door also enters the basement, so this these both give access to the shared space and the area they were renting. My question is does having rented this in the past effect our capital gains exemption? My wife and I understand that we get a 500k exemption and we will be able to show some improvements on the house so I'm comfortable that we wouldn't have to pay capital gains ignoring the rental space, but how would the rental area effect the 500k exemption?

Thanks,

Richard

 

[LdiJ]

What is the name of your state (only U.S. law)? WA

We are planning to sell our house for a significant gain. We purchased in 2009 for 380k and are planning to sell it for around 850k with the potential for it to go for up to 950k. We also rented our basement out for the last 4 years ending January 1st of this year which has a kitchen and bathroom and two bedrooms (about 1/3 of our sq. footage). There is also an unfinished portion of the basement that is shared space. We have a door from our kitchen to the basement, and the back door also enters the basement, so this these both give access to the shared space and the area they were renting. My question is does having rented this in the past effect our capital gains exemption? My wife and I understand that we get a 500k exemption and we will be able to show some improvements on the house so I'm comfortable that we wouldn't have to pay capital gains ignoring the rental space, but how would the rental area effect the 500k exemption?

Thanks,

Richard

Yes...that is going to be a problem. You are going to have to pro-rate the capital gain between the rental percentage and your personal residence percentage and pay capital gains tax on the rental portion.

How did you do the depreciation on the rental? Hopefully you pro-rated there?

 

[davew128]

Yes...that is going to be a problem. You are going to have to pro-rate the capital gain between the rental percentage and your personal residence percentage and pay capital gains tax on the rental portion.

Not true. Unless a separate portion of the home, you do not prorate anything, you only recapture the depreciation. http://www.irs.gov/publications/p523/ar02.html#en_US_2014_publink100010381

This was a basement, not a separate dwelling.

 

[LdiJ]

Not true. Unless a separate portion of the home, you do not prorate anything, you only recapture the depreciation. http://www.irs.gov/publications/p523/ar02.html#en_US_2014_publink100010381

This was a basement, not a separate dwelling.

Based on the OP's description, and the fact that it has a separate kitchen and bath, its clearly a separate portion of the home. The only area they shared was an unfinished portion of the basement. It also had a separate entrance. The OP did not rent out a room, the OP rented out an entire apartment without sharing any living space at all with the tenant.

 

[davew128]

Based on the OP's description, and the fact that it has a separate kitchen and bath, its clearly a separate portion of the home. The only area they shared was an unfinished portion of the basement. It also had a separate entrance. The OP did not rent out a room, the OP rented out an entire apartment without sharing any living space at all with the tenant.

Doesn't change my answer, and most homes where I grew up had separate entrances into basements in addition to one from inside the house. Having a separate bath means little, having a separate kitchen might.

 

[LdiJ]

Doesn't change my answer, and most homes where I grew up had separate entrances into basements in addition to one from inside the house. Having a separate bath means little, having a separate kitchen might.

My answer doesn't change either. The information you cited specifically refers to units having a separate kitchen and bath.

In my opinion unless the tenants had free run of the common areas of the entire home, it was a separate unit. Unless the OP's family had free run of the non bedroom areas of the basement it was a separate unit. If that door between the OP's kitchen and the basement was usually locked, it was, without doubt, a separate unit.

 

[rjschwar]

The depreciation I think was pro-rated. I read publication 523 and I could see arguing either way that it is a separate unit, or that it is indeed part of the house. It has a bathroom, and more of a kitchenette. The stove isn't full size. The "separate entrance" is just the back door to our house that can be used to access any part of the house. We use that entrance all the time. The basement is like any typical basement where you can get in through the back door...which would give you access to the bedrooms downstairs, the unfinished basement, or the upstairs area. The basement bedrooms aren't conforming if that makes any difference. We did share more than just the unfinished basement. All the outdoor areas, hot tub, etc. were all shared, and we spent some time in "their" area and they were upstairs at times like "roommates" so I'm not sure how to differentiate this. For depreciation, we claimed some updates that were made to the the shared areas and I think those were divided based on percent of the house used as their main living space. I also would argue that we did indeed share living space. The unfinished area is a shop and workout area that both us and them used and it also has a washer and dryer that we shared.

As a side note. This is just a regular basement for our house. It can be treated as a Mother-In-Law as are common here in Seattle, but many people just use them as a basement for a single family.

Also what legally makes it a "kitchen"? Does it need a microwave? stove? fridge? what?

Lastly if it ends up that I have to prorate the gains, does that mean that I only get a portion of the 500k exemption for your personal home? To keep the math easy, say it is determined that they are a separate apartment and has to be treated as a rental and it is 2/5 of the home. Lets also assume that our gains on the entire house when we sell after all the closing costs, improvements, etc. are taken out is 500k. Does that mean we would owe capital gains on 200k, where if we had not rented we wouldn't owe any capital gains? Also, what would the rate be? 15%? This will nearly be what we made in income from the rental. So it may come down to because we have to pay capital gains that we wouldn't normally if we hadn't rented, we actually had to pay to rent our basement. Is that right?

Thanks,

Richard

 

[OK-LL]

This will be determined by your municipal codes, but typically the defining factor is a range/oven/cooktop (not microwave).

 

[rjschwar]

I should also add that our house is zoned as single family/residential use. Does this make a difference?

Thanks,

Richard

 

[LdiJ]

The depreciation I think was pro-rated. I read publication 523 and I could see arguing either way that it is a separate unit, or that it is indeed part of the house. It has a bathroom, and more of a kitchenette. The stove isn't full size. The "separate entrance" is just the back door to our house that can be used to access any part of the house. We use that entrance all the time. The basement is like any typical basement where you can get in through the back door...which would give you access to the bedrooms downstairs, the unfinished basement, or the upstairs area. The basement bedrooms aren't conforming if that makes any difference. We did share more than just the unfinished basement. All the outdoor areas, hot tub, etc. were all shared, and we spent some time in "their" area and they were upstairs at times like "roommates" so I'm not sure how to differentiate this. For depreciation, we claimed some updates that were made to the the shared areas and I think those were divided based on percent of the house used as their main living space. I also would argue that we did indeed share living space. The unfinished area is a shop and workout area that both us and them used and it also has a washer and dryer that we shared.

As a side note. This is just a regular basement for our house. It can be treated as a Mother-In-Law as are common here in Seattle, but many people just use them as a basement for a single family.

Also what legally makes it a "kitchen"? Does it need a microwave? stove? fridge? what?

Lastly if it ends up that I have to prorate the gains, does that mean that I only get a portion of the 500k exemption for your personal home? To keep the math easy, say it is determined that they are a separate apartment and has to be treated as a rental and it is 2/5 of the home. Lets also assume that our gains on the entire house when we sell after all the closing costs, improvements, etc. are taken out is 500k. Does that mean we would owe capital gains on 200k, where if we had not rented we wouldn't owe any capital gains? Also, what would the rate be? 15%? This will nearly be what we made in income from the rental. So it may come down to because we have to pay capital gains that we wouldn't normally if we hadn't rented, we actually had to pay to rent our basement. Is that right?

Thanks,

Richard

When I refer to common areas in this particular instance, I am talking about kitchen, bathroom, living room. You did not share those. Stove, Fridge and sink, even if not full sized, make a kitchen.

You have to both recapture depreciation (at your marginal tax rate) and pay capital gains based on your overall income on whatever percentage of the house belongs to the rental unit. Do a google search for capital gains rates as they now vary, depending on your income. You would have to recapture depreciation no matter what.

You were probably violating code in renting the unit out, since its zoned single residence, but that is irrelevant for tax purposes.

In my opinion, its a separate unit, in Dave's opinion its not. That is why you need a tax professional on board. You need someone who is willing to take an opinion and defend that opinion if the IRS audits your return. In my opinion you would be a prime candidate for an audit the year that you sell due to the fact that the rental income will be dropping from your tax return without a corresponding capital gain/loss transaction if you do not treat it as a separate unit.
That is too big of a risk to take, based on the amount of money we are talking about, unless you have a professional on board who feels that they can defend their position.

I personally would not take that position on your return without researching a whole heck of a lot of case law first...and then only if the case law supported that opinion.

 

[rjschwar]

So lets assume for a minute that we treat it as a different unit, are my numbers from the previous post correct? If we were to be audited, would they track down all of our previous tenants and try to talk with them as well? As I said, they did spend some time in "our space" and we spent some time in "theirs". I paid all the bills, and they kicked me back some money on them, which I declared on our taxes. To me they seem more like roommates than tenants, and for 30-40k in capital gains tax, I'll shop around for an accountant who would agree with me. It doesn't seem right that basically the entire amount that we would have gotten from any rent would be lost when we sell the house. We easily could have a situation where we basically paid to rent a few rooms in our house for the last 4 years.

Thanks,

Richard

 

[LdiJ]

So lets assume for a minute that we treat it as a different unit, are my numbers from the previous post correct? If we were to be audited, would they track down all of our previous tenants and try to talk with them as well? As I said, they did spend some time in "our space" and we spent some time in "theirs". I paid all the bills, and they kicked me back some money on them, which I declared on our taxes. To me they seem more like roommates than tenants, and for 30-40k in capital gains tax, I'll shop around for an accountant who would agree with me. It doesn't seem right that basically the entire amount that we would have gotten from any rent would be lost when we sell the house. We easily could have a situation where we basically paid to rent a few rooms in our house for the last 4 years.

Thanks,

Richard

I cannot answer that question because I know nothing about the rest of your income and tax attributes. It all works in concert. The lowest capital gains rate is zero percent for low/lowish income people who sell an asset, up to 20% for high income people, plus a 3% medicare surcharge. That is why I suggested that you google it, so that you can see articles where they explain the rates and income brackets.

Recapturing depreciation (which is on depreciation allowed or allowable) is a your marginal tax bracket, which can be anywhere from 0 percent to 38%.

Its always possible to find someone who will see it the way you see it. However, if they cannot defend that opinion in front of the IRS in an audit, you will not only end up owing the tax, but also interest and penalties, which will be substantial in the case of that much money.

Understating income is serious business when the income is substantial. If you were talking about 20k and 4k in tax instead of 200k and potentially 40k in tax it would be less risky to take a position.

 

[rjschwar]

We would be in the bracket that is 15% capital gains. My question was more concerning the 500k exemption. If it is determined that 2/5 is a separate apartment, then 200k would be the capital gains tax liability, or is that dependent on something other than square footage?

Thanks,

Richard

 

[FlyingRon]

The IRS accepts "any reasonable division." Ratio of square footage is reasonable. So is a count of the rooms. Note that depreciation recapture must be done even if you failed to depreciate the property. I'd recommend a tax professional. This isn't straight forward and you probably want to go back and amend the prior years taxes ASAP to take advantage of the deduction.

You may be able to reclaim the space as part of YOUR residence and still get the full exclusion (you've not indicated enough details here to make that determination), but you still need to deal with the depreciation when it's sold. Again a tax professional is going to be worth it.

 

[LdiJ]

We would be in the bracket that is 15% capital gains. My question was more concerning the 500k exemption. If it is determined that 2/5 is a separate apartment, then 200k would be the capital gains tax liability, or is that dependent on something other than square footage?

Thanks,

Richard

Its square footage unless you can prove some other method is reasonable. You would need to minus out the unfinished basement part of the square footage unless that wasn't included in the square footage to start with.

It also doesn't work quite the way that you think. You need to leave the whole 500k exemption out of the equation. You figure out the ACTUAL gain on the property, and then prorate it between personal and rental. Then, you get to take an exemption of up to 500k on the personal side, and pay capital gains tax on the residential side.