If you have ever considered buying a multi-unit building and renting out one or several units you are not alone. Potential positives to these properties include that real estate often increases in value, they may qualify for residential loans, they may be easier to manage due to being under one roof and these properties offer rental income to subsidize any mortgage payments.
However, there are also tax considerations, such as taxability of a sale, deductibility of losses and you must determine if it qualifies as a trade or business, thus the Qualified Business Income (QBI) deduction.
Taxability on Sale
Internal Revenue Code (IRC) Section 121 allows taxpayers to exclude a gain from the sale of a principal residence up to $250,000 if filing as single and $500,000 if filing married filing jointly, subject to limitations and qualifications. The main rule is that “during the five-year period ending on the date of the sale or exchange, such property has been owned and used by the taxpayer as the taxpayer’s principal residence for periods aggregating two years or more” (IRC Section 121(a)). The exclusion is available once every two years and may be made on only one property at a time. If the property was acquired by a like-kind exchange (Section 1031 exchange), then the Section 121 exclusion will not apply for the first five years after the property was acquired via the exchange.
For a multi-unit property sale with a separate part of the property used for business or a rental — such as an Accessory Dwelling Unit (ADU) or a two- or three-flat with designated rental units — the taxpayer may not exclude gain on the separate part of the property used for business unless they owned and lived in that property for two out of the previous five years before the sale. Regardless, any deprecation recapture (Section 1250 gain) cannot be excluded via Section 121.
Related Read: Reintroducing Accessory Dwelling Units in Chicago
If instead of a multi-unit property sale, the taxpayer rents out a room in their main home and then sells it, there are different sale consequences. The taxpayer would be entitled to the full Section 121 gain exclusion on the whole home including the room rented if they qualified based on the standard rules. However, any depreciation allowed would be required to be reported as unrecaptured Section 1250 gain and would not be able to be excluded. The key here is that the part of the property used for business or rented is within the home, such as a bedroom, and is not a separate unit or space.
Deductibility of Losses
Real estate rentals sometimes generate losses. There are several rules at play when figuring out if losses are deductible in the year that they are related to or if they need to be carried over to future years.
Active participation allows taxpayers to offset up to $25,000 of passive losses generated from real estate activities ($12,500 for married filing separately) against non-passive income. The taxpayer must own 10% (by value) of all interests in the activity throughout the year and actively participate. Active participation is determined based on facts and circumstances such as participating in management decisions for the property and finding and approving contractors and service providers. The $25,000 maximum deduction is reduced by 50% of each dollar when the taxpayer’s adjusted gross income (AGI) is above $100,000 and is completely phased out if AGI is $150,000 or more.
Real estate professionals may deduct non-passive losses from rental real estate and would not be limited to passive loss rules. In general, the individual must perform more than half of personal services in real estate trade or businesses. They also must perform more than 750 hours of service during the tax year on real property trades or businesses in which the taxpayer or spouse materially participates. Hours spent as an employee do not count unless you own at least 5% of the business.
Qualified Business Income Section 199a Deduction
Real estate rentals may qualify for up to a 20% deduction of net business income. However, to qualify, rentals need to be classified as a trade or business as opposed to an investment. For information on what qualifies a real estate rental as a trade or business please read Determining if a Property is a Business or an Investment and IRS Provides Final QBI Real Estate Safe Harbor Rules, which discuss the topic.
Buying a real estate property in which you can both live and collect rental income can be very appealing. However, there are many factors at play such as the tax considerations discussed here and other non-tax issues like the real estate market, loan considerations and much more. It is important to reach out to professionals who can guide you through the process so you can make an informed decision.
For more information, contact Joshua Goldschmidt at [email protected] or call him at 312.670.7444. Visit ORBA.com to learn more about our Real Estate Group.