How to Report an Owner-Occupied Duplex Converted to a Rental

Turning a duplex that was once your primary residence into a rental property comes with important tax implications. The IRS treats this conversion differently than a fully rented investment property, requiring careful reporting to ensure compliance and maximize deductions.

Handling rental income, shared expenses, depreciation, and passive activity rules correctly is essential for accurate tax filing. Additionally, insurance coverage may need adjustments to reflect the change in use.

Rental Income Allocation

When converting a duplex from an owner-occupied residence to a rental, rental income must be allocated correctly. The IRS requires that only the portion of the property used as a rental be reported. If half of the duplex is rented, only that income is taxable.

The rental portion is typically determined by square footage. If the rental unit occupies 50% of the livable space, then 50% of the income is reported on Schedule E of Form 1040. If the rental unit is larger or smaller than the owner-occupied portion, the percentage must be adjusted accordingly. This percentage also determines how expenses like mortgage interest and property taxes are divided, ensuring only the rental portion is deducted.

Rental income includes more than just monthly rent. Payments such as pet fees, parking fees, or utility reimbursements must also be reported. Security deposits are not considered income unless retained for damages or unpaid rent. If returned to the tenant, they are not reported.

Expense Deductions for Shared Spaces

For a duplex that is partially rented and partially owner-occupied, expenses related to shared spaces must be divided appropriately. Areas such as hallways, driveways, laundry rooms, and yards require a reasonable allocation method. The IRS allows deductions based on square footage or usage.

Utilities that service the entire property, like water, electricity, and heating, must also be split. If separate meters exist, the exact rental portion can be calculated. Without separate meters, costs can be divided based on the number of occupants or the square footage of the rental unit. The same applies to services like landscaping, snow removal, and trash collection.

Repairs and maintenance must be categorized carefully. If a repair benefits only the tenant’s unit, it is fully deductible as a rental expense. If it benefits the entire property, such as a roof or plumbing repair, only the rental portion can be deducted. Capital improvements, such as installing a new HVAC system or replacing the roof, must be depreciated rather than deducted in full the year they are incurred.

Depreciation Methods

When converting a duplex into a rental, depreciation becomes a key tax consideration. The IRS allows property owners to recover the cost of the rental portion over time, reducing taxable income. Residential rental property is depreciated using the Modified Accelerated Cost Recovery System (MACRS) over 27.5 years, as outlined in IRS Publication 946. Only the structure—not the land—can be depreciated, making an accurate allocation of property value essential.

The depreciable basis starts with the original purchase price, plus any capital improvements made before conversion. If the duplex was owner-occupied before being rented, the basis for depreciation is the lower of the property’s adjusted cost basis or its fair market value at the time of conversion. For example, if a duplex was purchased for $300,000, with $60,000 allocated to land, the depreciable portion would be $240,000. If the fair market value at conversion is lower than this adjusted basis, that lower value must be used.

Depreciation is calculated using the straight-line method under MACRS, meaning equal amounts are deducted each year. The first year’s deduction is prorated based on the month rental activity begins, following the IRS mid-month convention for residential real estate. If the rental portion is 50% of the total property, then only half of the annual depreciation applies to rental income.

Passive Activity Rules

The IRS classifies rental activities as passive, meaning losses from a rental unit can only offset passive income, not wages or other earnings. This limitation, outlined in IRC Section 469, prevents taxpayers from using rental losses to reduce overall taxable income unless they meet specific exceptions. One such exception applies to real estate professionals who materially participate in rental activities, requiring more than 750 hours annually and making it their primary business. Most owners of a converted duplex won’t meet this threshold, making passive activity rules a key factor in tax planning.

For those with adjusted gross income (AGI) under $100,000, the IRS allows up to $25,000 in passive losses to offset non-passive income under a special allowance for active participation. This threshold phases out between $100,000 and $150,000 of AGI, reducing the deduction by $0.50 for every dollar over the lower limit. Active participation requires only management decisions such as approving tenants or handling repairs. If AGI exceeds $150,000, passive losses can only offset passive income, with unused losses carrying forward indefinitely.

Insurance Coverage

Converting an owner-occupied duplex into a rental requires updating insurance policies. Standard homeowners insurance does not provide adequate coverage for rental activities, making a landlord insurance policy necessary. This typically includes property damage protection, liability coverage, and loss of rental income if the unit becomes uninhabitable due to a covered event. Without this adjustment, claims related to tenant-occupied portions may be denied.

Liability protection is particularly important, as landlords can be held responsible for injuries or damages occurring on the rental premises. A comprehensive landlord policy should include at least $500,000 in liability coverage, though higher limits or an umbrella policy may offer additional protection. Requiring tenants to carry renters insurance can also help mitigate risks by covering their personal belongings and providing liability coverage for damages they may cause.