A duplex gives you the best of both worlds. You get to take advantage of the preferential financing available for one-to-four-unit residential properties while you also get to enjoy the investment and tax benefits of owing rental property. Not only can you make money on your duplex, but you can also enjoy some or all of that money tax-free. Furthermore, these benefits accrue to you even if you live in one of the duplex's two units.
Operating Expense Writeoffs
While you have to report the income you earn from your duplex, you can deduct all your operating expenses, as long as the Internal Revenue Service would consider them "ordinary and necessary." Your operating expenses don't only include obvious things like what you spend on property taxes and interest or utilities and maintenance, though. You can also write off management fees, a portion of your cellphone bill if you take rental calls on it, or even the cost of traveling to the property if you don't live in it.
The IRS lets you depreciate your duplex building, as well. To depreciate it, have your CPA help you allocate the property's value between the building and the land. Once you determine the value of the building alone, divide it by 27.5, which is what the IRS considers the building's life to be. You can then claim that amount every year for 27 years, and a half deduction in the 28th year. This reduces the taxable income from your duplex without you having to spend anything out of pocket.
Passive Activity Losses
Given the ability to write off depreciation and other soft expenses like building-related travel and cellphone usage, it's completely possible for you to end up with a taxable loss on the property. The IRS might let you use those losses to offset other income on your return. You can claim your actual losses, up to $25,000 per year, against your income if your adjusted gross income is $100,000 or less. You lose $1 of write-off for every $2 of income above $100,000, which means that if your AGI is $150,000 or more, you can't claim the write-off.
Capital Gains Shelter
When you sell investment property, you normally have to pay both capital gains tax on your profit and Section 1250 recapture tax on your accumulated depreciation if you sell for more than your depreciated basis. Since a duplex is an investment property, you can do a tax-deferred exchange if you choose to use the proceeds of the sale to buy another investment property. A 1031 exchange lets you carry your basis forward and avoid having to pay taxes until you eventually cash out of real estate someday or the law changes.
When you live in one half of a duplex, nothing really changes from a tax perspective. In essence, you have two houses. The half you live in gets treated as a personal residence while the half you rent out gets treated as an investment property. There are some benefits to this. You're allowed to allocate the cost of any shared expense on a 50/50 basis between your unit and your tenant's unit. For example, if you spend $50 per month for an Internet connection that you share with your tenant, half of the expenditure is deductible. Since you'd be spending $600 a year for your own Internet connection anyway, writing off $300 of it is a bonus for you.
Steve Lander has been a writer since 1996, with experience in the fields of financial services, real estate and technology. His work has appeared in trade publications such as the "Minnesota Real Estate Journal" and "Minnesota Multi-Housing Association Advocate." Lander holds a Bachelor of Arts in political science from Columbia University.