Tax implications on renting Duplex to sibling who is also co-owner

[Bob Sacamano]

Hello!

I can't seem to get a straight answer online by searching for this. My situation is:

1. W2 income puts me in 35% tax bracket.
2. Purchased a duplex with sibling as co-owner that will occupy one half of duplex.
3. Other half is rented out.
4. My sibling's W2 income is 12% tax bracket.
5. Sibling will pay less than half of market rate for rental
6. Interest is ~34k, rent is ~1.8k for half rented, sibling will pay 800

I'd like to deduct the full property interest from my income, but I'm unclear on the best way to structure this. I see 3 options, but maybe there's more?:

Option 1:
- Claim half interest, depreciation, property taxes, insurance, etc., claim rental income
- Sibling claims half interest as primary residence.

Option 2: 
- Claim full interest, claim rental income from tenants and sibling

Option 3:
- Claim full interest, claim rental income from tenants and charge sibling close to full rental (1.6k)

	Option 1	Option 2	Option 3 (full)
Rental Income	21600	31200	40800
Depreciation	-4550	-9100	-9100
Interest	-16800	-33600	-33600
Taxes	-3000	-6000	-6000
Insurance	-500	-1000	-1000
Garbage	-300	-600	-600
Total	-3550	-19100	-9500

Option 2 is the best, but because it's so far below market rate, I'm not sure if it that would cause problems. I can easily gift my sister the difference tax free, but then I'd have to pay taxes on the income still.

Also, can I deduct the full property tax and depreciation or only half with option 1? I'm assuming I can only do half for everything.

[Michael Plaks]

@Bob Sacamano

You made contradictory statements. Your sibling is a "co-owner" yet (s)he is paying rent. To whom, if (s)he is co-owner? I have to assume that your sibling is a co-owner on paper only, and it's you who actually funded this property and you're the one who is receiving rent, both from your tenant and from your sibling. And you would receive all the proceeds if the property was sold.

If my assumptions are incorrect, then my answer may need to be revised.

Now, under these assumptions... You do not have options, actually. There is only one correct way to report it. All other options may be "better" for you, but they are not compliant with the tax law.

You have two properties for tax purposes, not one. One unit is a personal property that you rent out to your sibling. You can deduct half of the interest and half of the property taxes as personal deductions, as long as you can itemize your personal deductions. And the rent collected from your sibling is fully taxable income to you. If you cannot itemize, this is a lousy situation to be in: rent is taxable and cannot be offset by any expenses.

The other unit is a rental property. Rent collected from the tenant will be offset by 1/2 of all expenses: mortgage interest, taxes, insurance, maintenance, etc. This half of mortgage interest cannot be claimed as your personal itemized deduction, it is a business/rental deduction. Also, you can depreciate 1/2 of the property, corresponding to the rental unit.

And you cannot deduct losses from the rental unit since your income is too high. Not ideal all around, but this is the situation you are in, as long as I interpreted your story correctly.

[Bob Sacamano]

@Michael Plaks thank you so much for your reply! One clarifying portion, the 800$/month my sibling is paying is intended to go towards their ownership into the home. Because they put nothing in the down payment, this would equate to at best .15% ownership per payment. Meaning I would still be the majority owner of the home.

From my understanding, here is my best legal way of filing. I have two properties 

1. 420k mortgage - 8% interest.
- I can take the full interest paid on half (210k with ~16k interest) for the rental
- I can take the full interest paid on the other half (210k with ~16k interest) as a personal residence second home.
2. 660k mortgage - 3.25% interest
- I can take 540k (to total the 750k personal limit) of the 660k.

Supposedly the IRS allows you to use any reasonable method to calculate your deductible mortgage interest expense. 

https://www.thetaxadviser.com/issues/2012/may/clinic-story-07.html

As of 2/28/2023, final regulations have not been issued.

[Nate Meeker]

@Bob Sacamano

Code Section 280a tells us that if you stay at a property you own during the tax year amounting to the greater of:

1. 14 days, OR
2. 10% of the total days you rent it to others at a fair rental price.

They will classify it as a personal residence. Losses will be disallowed and carried forward. Expenses must be allocated based on personal days occupied vs. tenant days occupied.

Friends or family renting below market value may be considered personal use days as well.