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(Also posted to the Real Estate Investing & Buying/selling a home boards)

Life in my new house is going well so far, but there's a new wrinkle I'm going to throw into things. I'm going to let out a room to a friend. He's trying to save cash to get his own place, and the rent at his apartment doesn't exactly help him out. I have loads of space, we get along well, and I'm happy to help him out.

Now, the question - should I report this as rental income? Or, more specifically, if I report it or not, what about the following:

1) What impact does this have on my mortgage? I know there's a distinction between primary-residence and investment-property; is there any negative side effect of blurring the line, ie "whoops, my note's due now" or "whoops, my rate just jumped .75%?

2) What is the impact of selling the home in the future? Again, I'll be living there, but it would also be a rental property.

3) What is the impact of this on investing in real estate in the future? I've read that unless you have previous landlord experience, you might have trouble getting a rental-property mortgage, since they won't allow you to show theoretical rental income when you apply. Would having a year's worth of documented rental income help later on?

4) What is the impact of this on deducting mortgage interest come tax season?

5) What is the impact of this on deducting home maintenance come tax season? I believe you can deduct a number of things on a rental property, again, the line seems blurred, since I'll still be living there.
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Now, the question - should I report this as rental income?

Yes, this would be rental income. You should report all of your income from whatever sources it is derived. Any exceptions to this would be somewhere in the tax code. The only exception I know of for your principal residence would be a short-term rental of 14 days or less.

Be aware that not everyone reports all of the income that they should. (Wink, wink, nudge, nudge). Also be aware that the only crime some mob bosses have done time for is for tax evasion. (Notably, Al Capone.)

Or, more specifically, if I report it or not, what about the following:

1) What impact does this have on my mortgage? I know there's a distinction between primary-residence and investment-property; is there any negative side effect of blurring the line, ie "whoops, my note's due now" or "whoops, my rate just jumped .75%?


I'll leave that one to the folks on the real estate investing board. I suspect the cure for any default would be that you loan becomes due. I doubt that they would (or even could) simply raise your interest rate.

2) What is the impact of selling the home in the future? Again, I'll be living there, but it would also be a rental property.

This one is still a bit new (and I rarely deal with it professionally) so correct me gently if I'm wrong.

I believe the only impact would be from the depreciation you take (or should have taken) while renting the house. That depreciation would not be subject to the $250k ($500k for marrieds) exclusion from income. It would be taxed at a 25% rate.

3) What is the impact of this on investing in real estate in the future? I've read that unless you have previous landlord experience, you might have trouble getting a rental-property mortgage, since they won't allow you to show theoretical rental income when you apply. Would having a year's worth of documented rental income help later on?

That's definitely one for the mortgage pros. I won't even hazard a guess here.

4) What is the impact of this on deducting mortgage interest come tax season?

Pretty simple. You need to split your mortgage interest between the residence portion and the rental portion. One way would be to base the split on the square feet you rent out compared to the total square footage of the house. Common areas (kitchen, living room, etc.) could be split 50/50 if the rental includes their use.

Once you've determined the split, you report the residence portion on schedule A and the rental portion on schedule E. You would do the same with property taxes.

5) What is the impact of this on deducting home maintenance come tax season? I believe you can deduct a number of things on a rental property, again, the line seems blurred, since I'll still be living there.

You've got the same split issues as with the mortgage interest. But once split, the residence portion is not deductible, while the rental portion would go on schedule E. Utilities would be included in the maintenance expenses.

Since a portion of most of your maintenance expenses will be deductible, you'll want to keep track of them so you can properly claim them at tax time.

--Peter
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The one thing missing from your list of questions, and it isn't a tax question, is whether your local zoning laws allow you to rent out a room. The financial impact of running afoul of local zoning ordinances can be far greater than the tax impact.

Ira
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"Be aware that not everyone reports all of the income that they should. (Wink, wink, nudge, nudge). Also be aware that the only crime some mob bosses have done time for is for tax evasion. (Notably, Al Capone.)"

OK if I read this right your expert tax opinion would be that if OP is not going to report his rental income, then he ought to go into business as a mob boss, since they will only put him inside for tax evasion anyway?

:-)

BF
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OK if I read this right your expert tax opinion would be that if OP is not going to report his rental income, then he ought to go into business as a mob boss, since they will only put him inside for tax evasion anyway?

<grinning, definitely grinning>
No. I'm saying that compared to extortion and murder, tax evasion is pretty easy to prove.

--Peter
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ptheland, I think you just made the Fool's $25 fee worth the money this year. Thanks!

So, what this comes down to is that I can go two routes, report, or not report.

Reporting:
Take depreciation (good thing)
Take 50% interest as tax write off (for residential half - good thing)
Take 50% interest as tax write off (for rental half - good thing)
Take 30% loss on total rental income (taxes - bad thing)
Take 50% of utils/maintenance as tax write off (for rental half - good thing)

Not reporting:
100% of interest as tax write off (good thing)
100% of rental income (good thing)
0% of utils/maint deductible (bad thing)

Did I miss soemthing else here? It looks like my best bet is to save all the bills/receipts that I'd need if I report, add it all up with whatever depreciation benefits there are, and see if that deduction offsets the 30% of rental income I'd lose, right?
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So, what this comes down to is that I can go two routes, report, or not report.

Let me make one thing clear. While I've joked about it a bit in the thread, not reporting the income is technically not an option. This is taxable income and should be reported. Not reporting it would be to file a false tax return.

--Peter <== no longer joking
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Let me make one thing clear. While I've joked about it a bit in the thread, not reporting the income is technically not an option. This is taxable income and should be reported. Not reporting it would be to file a false tax return.

Understood completely. But, it IS technically an option. Hell, you can file a tax return that's just a photocopy of of your left foot, if you want to. It's stupid, it'll land you in deep trouble, but it IS always an option :-).
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You missed a couple:

Reporting:
Doing what the law requires

Not reporting:
Filing a fraudulent return

Forget all the numbers, these considerations alone should suffice.

Lorenzo
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Forget all the numbers, these considerations alone should suffice

If money changes hands, I'll agree with you. But there's other options; ie trading his motorcycle for a place to stay, or something similar. I'd be much more inclined to keep things simple, and have a standard rent payment, if I came out ahead by reporting the income. I'm not going to break any laws, but I'm not going to get taken for a ride by doing a friend a favor, either.
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Forget all the numbers, these considerations alone should suffice

If money changes hands, I'll agree with you. But there's other options; ie trading his motorcycle for a place to stay, or something similar. I'd be much more inclined to keep things simple, and have a standard rent payment, if I came out ahead by reporting the income. I'm not going to break any laws, but I'm not going to get taken for a ride by doing a friend a favor, either.


Money doesn't have to change hands, value does. Barter is taxable income.

Ira
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Understood completely. But, it IS technically an option. Hell, you can file a tax return that's just a photocopy of of your left foot, if you want to. It's stupid, it'll land you in deep trouble, but it IS always an option :-).

Sounds to me like you understand things pretty well, then. It's certainly not my intent to preach, but I can't recommend that someone join the underground economy, either.

Actually, you'd need to add things up to find the impact on your tax return. It may be that reporting things on the up-and-up actually reduces your current taxes very legitimately because of the allowable deductions.

Then again, if the legit deductions are low, it might add to your current taxes.

--Peter <== who knows people in your situation who've gone both ways.
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1) What impact does this have on my mortgage? I know there's a distinction between primary-residence and investment-property; is there any negative side effect of blurring the line, ie "whoops, my note's due now" or "whoops, my rate just jumped .75%?</>

First, you have what would be determined to be almost a "roommate" situation. I am sure you will be taking the amount of your mortgage along with the cost of utilities, etc. and determining the amount to be paid by your friend. Since this home is your principal residence and you will continue residing there, there will be no change as far as your mortgage is concerned.

Donna (a real estate paralegal and tax preparer during the season)
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<Forget all the numbers, these considerations alone should suffice.>


There is another consideration that I have not seen mentioned here. Every year I have to state in writing to my home insurer that I do not have any tenants living in my home. I don't know if the costs would increase significantly, but they would have to be legally notified unless you want to take yet another chance.

If you had some incident (say a fire caused by a tennant or they fall and injure themselves, etc.) the insurance company would be within their rights to not cover your loss since you made a false statement on your annual renewal. Such a string of events may be less than likely to happen, but they could leave you on the wrong side of your insurance company, your mortgage company, the IRS, your state taxing authority and your local government for code violations. Becoming a landlord should never be a casual decision.


B
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The cost of the relevent rental insurance is a very small part of my homeowner's insurance (maybe around $50 for relocation and additional liability?)

- Megan
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<The cost of the relevent rental insurance is a very small part of my homeowner's insurance (maybe around $50 for relocation and additional liability?)>


My point was not really about the cost of the added insurance. If one is reporting everything it should not be a big factor. However, if one decides to not report the income, but have it on record that they have tennants living on their property, they are putting themselves at risk with the tax people and possibly the local authorities. If they never report the income and never notify their insurance company that they have tennants, they have an even greater risk of liability.

I am sure that lots of people have gotten away with not reporting the income. I am a believer that cutting corners will eventually catch up to you in the long run. When it does catch up with the person, the price to pay is usually significantly higher than if they had done what they were supposed to do in the first place.


B
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Actually, you'd need to add things up to find the impact on your tax return. It may be that reporting things on the up-and-up actually reduces your current taxes very legitimately because of the allowable deductions.

If I do end up renting out a room, I'll definately be back around tax time, asking questions. If I rent a room out, I'll definately be saving utility bills, maintenance bills, etc so I can make a good decision.

In the mean time, one more (possibly stupid) question:

If it's just me living here, 100% of my mortgage/HELOC interest is deductible, right? Is 100% also deductible if I have a roommate (50% for the residence, 50% for the rental)? That's liable to be the make-or-break of it.
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If it's just me living here, 100% of my mortgage/HELOC interest is deductible, right?

Right.

Is 100% also deductible if I have a roommate (50% for the residence, 50% for the rental)?

Well, no. If 50-50 is the right split, then only 50% of your mortgage interest would be deductible on Sched A. Likewise, 50% of your property taxes. The other 50% of interest/taxes is not a deduction, but is a business expense that goes against rental income. (Other business expenses are things like depreciation, repairs to the rental property, and some portion of insurance costs.) So you have rental income on the one hand, and rental-related expenses on the other. If you have a net gain, it's business income. It might be a wash (unlikely). If it all nets out to a loss, it may or may not do you any good, depending on your AGI. (If you have a high enough AGI, passive-activity losses are phased out. See Pub 925.)

Lorenzo
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I recently bought a house, and although I don't plan to have a roommate immediately I might want to do so down the road. I discussed the situation with several insurers, mostly because I also have galvanized pipes (80 year old house) and some insurers won't cover them these days. Finding someone who would cover galvanized pipes long enough for me to go through closing, plus be cool with roommates and dogs, was a challenge.

What I found was that insurers have a broad range of attitudes toward non-relatives living in your home. The insurer I used for my condo insurance wouldn't allow roommates at all. End of story. I wound up using another agency from the same company who was fine with it. The agent who insured the condo is out of state (technically, it's a few miles). Don't know if that makes a difference or it's really just up to the agent.

Some companies would cover only if you had a "mother in law" apartment in the basement with a separate entrance and they couldn't get into your space. Others hated that idea, didn't want them to have their own kitchen, wanted them to be upstairs with you in your kitchen where you could keep an eye on them. In all cases, the insurance company had to be informed about the additional person.

A couple of agents recommended that I require a roommate to have their own separate renter's insurance policy so if they filed on it I wouldn't have a report on my homeowner's insurance. This sounded like a good idea.

S.
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