The Owner-Occupied Tax Deduction
Owner-occupied rental properties like duplexes receive extremely favorable tax treatment. The Internal Revenue Service treats them as a hybrid of two properties -- a personal residence and an investment real estate property -- and lets you claim both personal and investment deductions against them. With a good tax strategy, you can use this ability to not only reduce your taxable investment income but also effectively write off a portion of your personal expenses that wouldn't be deductible if you just had a single-family residence.
Before you can start writing off your owner-occupied property, you need to split it up. For a duplex, you can just split most expenses down the middle. If your property has more than two units, though, allocate the expenses on a per-unit basis or on some other basis as you and your accountant determine. While most expenses get shared between all of the units, expenses that benefit only a specific unit should be allocated to that unit. For example, property taxes that cover the entire property get allocated across all of the units, while the cost of fixing a leaky faucet in the rental unit can be completely assigned to that unit.
The Owner-Occupied Unit
The IRS treats your owner-occupied unit just as it would treat a house. If you itemize deductions, you can write off the share of your mortgage interest and your property tax that corresponds to your unit. Taxpayers who don't itemize can't claim these deductions, though. When you sell your building, regardless of whether or not you itemize, you can also apply the home sale capital gain exclusion to your unit’s pro-rata share of the sale proceeds.
For your rental units, the IRS requires you to file the Schedule E form. On Schedule E, report all of the income from your rented units and subtract all of your rental expenses and everything that you spend on its operations is deductible. This goes well beyond property taxes and mortgage interest to include your management fees, utilities, insurance, repairs and just about anything else that the IRS will accept as being "ordinary and necessary." Since the Schedule E is a separate form from the rest of your tax return, you can claim these expenses even if you don't itemize. Unfortunately, when you sell your property, you are subject to capital gains taxes and depreciation recapture taxes unless you use that portion of your sale proceeds to buy more rental units. In that case, you'll can defer all of your taxes by doing a 1031 exchange.
Maximizing Your Deductions
When you have a duplex or other multi-unit owner occupied property, you get to effectively deduct some of your personal expenses. For example, if you have an Internet connection that you share between the two units, it probably costs the about same as it would cost to get an Internet connection just for yourself. However, since it's shared, you can write off half the cost of it as a rental expense on your Schedule E. This can also apply to repairs that benefit all parts of the building.
Beating Deduction Limitations
Since your rental property expenses are written off separately from your Schedule A, none of the limitations that apply to personal deductions apply to them. For example, the Alternative Minimum Tax eliminates many deductions, including the ability to write off property taxes. If you pay the AMT, you won't be able to write off your unit's share of the property taxes, but you will be able to claim the rental share on Schedule E. The same scenario applies if your income is high enough to fall under the Pease limitation. As of 2013, the Pease limitation gradually phases out property tax and mortgage interest deductions for married taxpayers with incomes over $300,000 and singles with incomes over $250,000. As with the AMT, it may limit your unit's deductions, but it doesn't apply to your Schedule E expenses.
- IRS: Publcation 527 - Residential Rental Property
- IRS: Instructions for Schedule E (Form 1040)
- Asset Preservation Inc: Capital Gain Tax Rate Increases in 2013
- Forbes: Pease Limitation Puts a Lid on Itemized Deductions for Wealthy Folks
- IRS: Schedule A (Form 1040)
- Bankrate: Capital Gains on the Sale of a Duplex
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.