If you’re a homeowner in Newport Beach, Costa Mesa, or other parts of California and you rent out individual rooms in your home, and you still live there as your primary residence, you may wonder how this impacts your taxes when it comes time to sell. Specifically, can you still qualify for the IRS Section 121 deduction — the tax break that can save you up to $250,000 (single filers) or $500,000 (married couples filing jointly) in capital gains taxes? The answer is: Yes, you can still qualify for this significant tax break, but there are key details you need to understand and it boils down to shared spaces.
What Is the IRS Section 121 Deduction?
Review our full article on the IRS Section 121 deduction here (link to 121 article).
In summary: the IRS Section 121 deduction, often referred to as the “Homeowner’s Exclusion,” allows individuals to exclude up to $250,000 (or $500,000 for married couples) of capital gains from the sale of their primary residence if they meet two simple tests:
- The Ownership Test: You must have owned the home for at least two of the last five years leading up to the sale.
- The Use Test: You must have lived in the home as your primary residence for at least two of the last five years.
Renting Out Rooms: The Shared Space Scenario
But what happens if you’ve been renting out rooms in that home? Do those rental activities disqualify you from the exclusion? The good news is that if you’re renting out rooms within your primary residence, the answer is no—at least for most of the home’s value.
When you rent out rooms within your home—such as a spare bedroom or basement—you can still qualify for the Section 121 deduction, as long as the rented space is part of your living area and you’ve lived there long enough to meet the ownership and use tests. However, there’s an important catch:
- Depreciation Recapture: If you’ve taken any depreciation on the rented space (for example, if you’ve been deducting expenses related to renting out the room), you’ll have to “recapture” the depreciation when you sell. This means you’ll need to report the amount of depreciation as ordinary income on your tax return.
Example:
Let’s say you’ve lived in your Newport Beach home for five years and rented out a spare bedroom for three of those years. You can still exclude up to $250,000 (single) or $500,000 (married) in capital gains under Section 121. However, if you claimed $5,000 in depreciation for the rented room, you’ll need to report that $5,000 as income when you sell the home.
Separate Units: A Different Story
The rules change if you’re renting out a separate portion of your property—like a detached guest house, ADU, or second unit in a duplex. In this case, the IRS treats the rental space differently from the part you use as your primary residence, and you’ll need to split the sale into two parts:
- Residential Portion: You can exclude the gain on the part of the property you lived in, provided you meet the ownership and use tests.
- Rental Portion: You cannot exclude the gain on the portion of the property used for rental or business purposes unless you also meet the ownership and use tests for that specific part.
For separate units or rental spaces, you’ll need to allocate the sale price between the residential and rental parts and report the gain for the rental part separately—often using IRS Form 4797.
Example:
Imagine you own a duplex in Costa Mesa, where you live in the front unit and rent out the back unit. You sell the duplex after five years. You can exclude the gain on the front unit where you lived, but the gain from the back unit (the rental part) is taxable, and you must report it separately. If you didn’t live in the back unit for two of the last five years, you won’t qualify for the exclusion on that portion.
Important Considerations for Homeowners Renting Out Rooms
Whether you rent out a spare bedroom in your primary residence or a completely separate unit, there are key tax considerations to keep in mind:
- Recapturing Depreciation: Even if you can exclude the gain from the sale of your home, any depreciation you claimed for rental use after May 6, 1997, must be recaptured and reported as ordinary income.
- Allocation for Separate Units: If part of your property is separate (like a detached guest house or duplex), you’ll need to allocate the gain and report it separately. Only the part of the property you lived in as your primary residence qualifies for the Section 121 exclusion.
- Keep Detailed Records: It’s essential to keep clear records of how much of your home was rented and for how long, as this will impact your calculations when you sell.
The Bottom Line: Yes, You Can Still Qualify
The key takeaway is that renting out rooms within your home does not disqualify you from claiming the Section 121 deduction when you sell your primary residence. As long as the rented space is within your living area (such as a bedroom or basement), and you meet the ownership and use tests, you can still exclude up to $250,000 or $500,000 of the gain. However, you’ll need to pay attention to depreciation recapture rules.
For those renting out separate units or detached spaces, the story is a bit different—gains on those portions of the property may be taxable, and you’ll need to allocate the sale price between residential and rental uses.
At Lucas Real Estate, we specialize in helping homeowners navigate the complex interactions between rental income, tax exclusions, and real estate sales in Newport Beach, Costa Mesa, and the surrounding costal orange county areas. If you have questions about how renting out rooms or separate units might impact your tax situation when you sell, don’t hesitate to reach out for personalized advice.
Questions or Need Help?
Thinking of selling California real estate, we would love the opportunity to assist – we provide full service sales in Newport Beach, Costa Mesa and surrounding coastal areas. If you are seeking to sell your home in Newport Beach, Costa Mesa or the surrounding areas, call or email anytime for a free brief consultation – info@lucas-real-estate.com or 949-478-1623.
We provide advice and consultation for sales throughout the state of California. Call or write anytime or book a consultation. (Book a consultation here.)
– Devin Lucas
Author Devin R. Lucas is a REALTOR®, Real Estate Attorney, and real estate Broker, specializing in Newport Beach, Costa Mesa and Orange County coastal communities, serving individual, Trustees and investors in residential real estate.
sources:
- IRS Publication 523: Selling Your Home. This publication provides detailed guidance on the Section 121 exclusion, including depreciation recapture and how to treat homes with business or rental use. IRS Publication 523
- IRS Publication 587: Business Use of Your Home. This publication covers the rules for homeowners who use part of their home for business or rental purposes and how to calculate depreciation and recapture. IRS Publication 587
- IRS Publication 527: Residential Rental Property. A helpful resource for understanding how rental properties are treated by the IRS and the related tax rules. IRS Publication 527
– Devin Lucas
Author Devin R. Lucas is a Real Estate Attorney, Broker and REALTOR®, specializing in Newport Beach, Costa Mesa and Orange County coastal communities, serving individual and investors in residential real estate, including leasing and select local property management.
Lucas Real Estate – Attorney Devin Lucas and CPA Courtney Lucas – are experts in California property tax matters including Propositions 13, 58, 193, 60, 90 and new Proposition 19.
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Lucas Real Estate is a unique full-service residential real estate brokerage providing related residential real estate legal services and real estate tax considerations and planning, based in Newport Beach, California. | Devin Lucas is a licensed California Real Estate Attorney, Real Estate Broker and REALTOR® | Courtney Lucas is a California licensed CPA and REALTOR®
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