Tax consequences of a primary residence basement rental

I’m hoping to tap the collective expertise on the boards to understand how I can best capture expenses used in my landlording of my primary residences’ basement. Here is the scenario, in 2007 I finished my “unfinished” basement to let my sister live in for a short time and ultimately use as a rental unit. My sister stayed in it for about 10 months and then moved out in 2008 (I did not charge her any rent). Upon her leaving, I put the place as available for rent and was successful in getting $700/month on a M2M lease beginning January 1, 2009. Here are my questions:

  1. I did all the work myself and in the process spent about $25k on materials. How do I handle these expenses that are spread over a couple years? I’m guessing that I get to capitalize the entire expense and cannot directly expense any of it, but am I screwed because I did the majority of the work in 2007 where I didn’t receive any rental income and thus did not capitalize any of it at the time? Can I capitalize it in 2008 and be able to recapture all that depreciation? Or since I didn’t have a renter in there until 2009, do I have to wait until filing the 2009 return to capitalize?

  2. Secondly and less importantly, I spent probably around $2k on tools used in the project, e.g. framing nailer, mitre saw, table saw, etc. am I able to capture any of those dollars in some way and deduct them from my income?

Please let me know if I need to provide any additional detail or if I’ve been unclear on the details. Thanks in advance for your help.

Have you considered the fact most jurisdictions frown upon illegal rentals and courts routinely award all paid rent to the tenants? Some states will not even grant you an eviction for an illegal unit.

Add your materials cost to the property basis and depreciate. Some tax expert advocate a componetization method where the major home systems are broken down and depreicated separately. You can start depreciating and deducting expenses from the time the unit is made available for rent.

Personally, I would expense the tools even if depreciation was required.

First, renting to relative means property is essentially not treated as a “rental” (cannot deduct losses that exceed income) unless rent paid is at least 80% of FMV rent. So sister’s time in does not allow deductions at all, since no rent was charged.

Second, most of the costs incurred for materials are likley required to be capitalized (added to cost of building). The capitalized costs are depreciable (land excepted) once the property is “in service”, which means “ready to rent” as opposed to “actually rented”. Evidence of “in service” is usually certificate of occupancy or advertising the place for rent.

Strictly speaking, the tools are supposed to be capitalized. They may be elligible for Code Section 179 depreciation all in one year. Customarily, small tools are simply expensed under supplies expense or the like. Either way, the tools are only deductible to the extent that they are used for business - so if they are used 64.36% for business, then you can depreciate/expense 64.36% of the tools.

There is an exception which prohibits taking a Section 179 expense deduction for a rental property activity.

Code Section 179, as I said, “may” apply. Specifically, if renting property rises to the level of a “trade or business”, as opposed to a mere activity for production of income AND the property is not part of the dwelling/lodging, then Section 179 does apply.

John Hyre

I’m not interested in doing anything illegal. What specifically makes this basement, or any other for that matter, illegal?


It seemed apparent from the facts and circumstances described that willmy21 is not engaged in an active income trade or business. He has simply converted his basement to a residential rental dwelling unit.

Did not hurt to clarify just in case willmy21 believed from your earlier response that he could take a Section 179 business expense for his residential rental activity.

The property must be zoned for mutli-family use. Did you pull permits for the work? Did you get a zoning variance?

We did pull the permits. The home is in a sub-division, where can I find what it is zoned for? We do not have a zoning variance, what would be the process of doing so?

My intention is to remain the resident of the house, while offsetting some of the mortgage payment by offering the basement for rent. Not sure if it matters, but it contains its own kitchen, bathroom, and private entrance.

After doing a little research, my home is zoned as PR 1-3 DU/AC which is located in Knox County. I found this passage which I think allows this type of situation:

"Knox County Zoning Ordinance

Residential dwelling units may be occupied by a family, a “functional family” consistent with the criteria established by this ordinance, or the following groups of persons unrelated by blood, marriage, adoption, or guardianship, including foster children:

  1. Two unrelated people and any of their children by blood, marriage, guardianship, including foster children, or adoption;
  2. Up to three people in the A, E, RA, R-AE zone districts and in houses, attached houses, and duplexes within any RB, TC, or PR zone districts;"

I think that #2 would allow it, no?

Usually, not, but I’m not in your area. Check with the inspectors who checked you work and they will know.

What is rentable would very much be a local custom issue, wouldn’t it?

My niece’s landlord in San Francisco was fined thousands, shown on the news and generally made an example of as a slumlord for dividing up an apartment illegally.

Here, in my small town, things are much more “Wild West” and relaxed. If no one complains and you don’t hurt anyone, you can do it.

A couple of years ago I bought a 2-unit building in a SFR neighborhood. When we were renovating we discovered that there was a heck of a lot of square footage being badly used, so the 2-unit became 3-units.

Our building inspector just stopped by one day and said “You gotta wire all the smoke detectors commercially if you are 3 units or I’ll sic the Fire Marshall on you.” I hadn’t known the code difference between 2 and 3 units.

Here if you just do a decent job they leave you alone. Everyone knows who you are and what you are doing. There are plenty of really bad slumlords and sub-standard buildings so good landlords are left alone.


Thanks for the input on the legality issue. Back to the tax issue, let me check to see if I have this right.

  1. For the $25k in materials including all the raw materials (wiring, plumbing supplies, 2x4’s,etc) plus kitchen cabinets, fixtures, countertops, appliances, all of it gets thrown into a capitalized bucket to be depreciated beginning on the put-into-service date of 12/9/08 (that is the date I purchased the ad to go in the paper so that is the date I’m using). Is this correct, even though I spent a considerable portion of these dollars in prior years (because my sister was living there, I never reflected any of these costs on any prior year returns in any way)?

  2. Can I depreciate the value of the unimproved square footage as well beginning on that same in-service-date (that is just the value of the basement area). Here is what I was thinking: take the appraised value of the overall property $320k (from the property tax record) times the percentage alloted for the structure which was 87% (the land being the other 13%). Then take that amount times the basement square footage percentage of 23%. So, $320k * 87% = $278k * 23%=$64k to be placed in service and depreciated beginning on 12/9/08.

  3. Sounds like I probably just ought to add the $2k worth of tools into the overall project cost of $25k and be done with it.

Any further help is greatly appreciated. Thanks a lot for confirming my thinking or setting me right…

The basement has been converted into a rental unit. The COST of the basement is your intial cost basis. Add to that, the cost of your renovation. Let’s say you paid $200K for the property ten years ago. The land is assessed at 13% of the property value, so, subtract $26K for the value of the land, to arrive at $174K for the initial cost basis of the building structure.

Using square footage, you have calculated the basement apartment comprises 23% of the building so your initial cost basis for the basement is $40K. To this, add the $25K cost of materials for your renovation, making your depreciation basis for the rental unit $65K on the day the property is placed in service.

I put the tools in a personal expense category. No capital expense allowed.