Tom ByrneParticipant11 months, 1 week ago
My home: a combination rental property and home studio. Tax implications?
I’m trying to work this out. I’ll be using monies won in a legal settlement to purchase a home which will include 2 rooms rented out and also a studio which I use exclusively for business purposes and clients as well as storage. I’m self-employed / sole proprietor. I’ve been seeking ways to stem the tax hurt from the settlement monies themselves, but I’ll settle for any advice someone has on how to treat my new status. Thanks in advance!2 Replies
Deborah SpenceParticipant11 months, 1 week ago
William PerezParticipant11 months ago
What an interesting situation you present. There are 4 aspects to your questions.
1) Tax impact of your legal settlement
2) Tax impact of buying the house — which itself has 3 aspects:
2a) Tax impact of renting out 2 rooms
2b) Tax impact of using a studio as a business space
2c) Tax impact of using a portion for personal use
As an overview, the tax treatment of the settlement may or may not be fully offset by any tax savings from the buying the property. To phrase this another way, you should set aside enough money out of your settlement to cover your tax obligations before deciding how much to invest in the real estate.
Now to address each aspect of your situation briefly.
1) Legal settlements are usually taxable. The underlying rule is that settlements are taxable based on the nature of the claim. Back pay, to give one example, would be taxed just like wage income. However, certain types of settlements for physical injury and sickness are usually non-taxable. Settlements for property damage could be partly non-taxable and partly taxable. So the bottom line here is to consult a licensed tax professional such as an Enrolled Agent or Certified Public Accountant so you can get really clear on how your settlement will be taxed, both federal and state.
2a) Tax impact of renting out rooms: rents received is taxable income. Against this you can deduct expenses related to the rental, such as a portion of the property taxes, a portion of interest paid on home loans, a portion of homeowners insurance, and a portion of the purchase price of the house. You’ll be taxed only on the net amount of rental income after allowable deductions are subtracted out.
2b) Tax impact of using studio as business space: a portion of the costs related to the studio can be deducted as a business expense against your self-employment income. This is called the home office deduction. This works just like the rental deductions: you will take a portion of the property tax, homeowners insurance, mortgage interest.
2c) Tax impact for personal use of the home: you can take itemized deductions on Schedule A for the portion of mortgage interest and property tax not deducted as rental or business expenses.
I hope this helps give you a brief overview of what’s going on.
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federally licensed tax professional and staff writer for FitSmallBusiness.com.