Goodspeed: Differences between living in and renting out a home


QUESTION:My sister and I are both married. She and her husband own a home. My husband and I don’t yet. We want to purchase a duplex, but can’t afford it. My sister and her husband said they would go in with us and rent out their side. All four of our names will be on the mortgage and title. What are the tax implications for each couple?

ANSWER: For you and your hubby, your side of the duplex will be considered your primary residence, and as such, owner occupied. For your sis and her hubby, their side of the purchase will be considered an investment. Let’s examine the tax ramifications for each in turn:

If you and your husband live in the property as your primary residence, you might get a benefit from the local taxing authority that levies your annual tax bill. You will also be able to deduct your real estate taxes from federal income taxes in an amount up to $10,000 annually for a married couple.

If you and your sister decide to sell the property at some point, if you and your husband have lived in your side as your primary residence for two out of the last five years, you will be able to exclude up to $500,000 ($250,000 for a single person) from capital gains taxes on any profit you make from the sale attributable to your side.

For your sister and her husband, their side of the duplex will be considered for tax purposes as an investment. The rent will be taxed to them as ordinary income. But they will have the ability to offset that income by expenses for the property, including their share of real estate taxes.

If and when the four of you sell the property, your sister and her husband will have to pay taxes on the profit from the sale of their side of the duplex.

As investors, your sister and her husband will be able to depreciate their interest in the building. This means your sister and husband can depreciate a portion of their costs while they own the property. This will help them reduce their annual federal income taxes - depending on how much profit they make from the property and other investments.

If and when your sister and husband sell, they will have to pay back the depreciation, known as recapture. They can defer paying all taxes, including the recapture of depreciation by employing a 1031 exchange. A 1031 exchange would require them to close on a replacement investment property of equal or higher value than the one being sold within 180 days of the sale of the current property.

There are other rules and requirements of a 1031 exchange, but they would be able to jump from owning one investment property to owning another one without paying federal taxes.

If you and your husband buy a primary residence and rent out your side of the duplex, it will become an investment property and you will be able to enjoy the same tax benefits as your sister.

Linda Goodspeed is a longtime real estate writer and author of “In and out of Darkness.” Email her at: