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We are currently renting a basement out to some friends of ours. We are asking a fraction of the price of what its worth. I understand the risk of renting without a certificate of occupancy.

The apartment is legal if it weren't for the zoning prohibiting basement apartments, I'd just mention that they have multiple exits, fire extinguisher, smoke alarms, etc.

I now am receiving money from them and I don't know what to do with that money come tax time. I am going to claim it, no doubt about it, but I don't know how I can do this? Should I fear the IRS contacting the building department? Can I claim deductions from the wear and tear of the renter or their utilities?

  • "Illegal" is a slippery word. In your case, the only definition of "legal" that matters is the IRS's. It is certainly not a Federal crime to rent an apartment which has fallen shy of local zoning, and even locally, this is a civil matter not criminal. A tax lawyer would know for sure, but I doubt IRS is going to hold you to the "can't deduct illegal expenses in excess of illegal gains" rule... and I wouldn't call it illegal income on my 1040 unless my tax advisor told me to. – Harper - Reinstate Monica Aug 5 '17 at 0:15
  • This question is a perfect fit for the Accounting site (currently a proposal in Area 51: area51.stackexchange.com/proposals/113560/… ) – Jacob Sep 20 '17 at 1:16
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The IRS demands and expects to be paid tax on all taxable activity, including illegal activity. If they expect drug dealers, hit men, and smugglers to pay tax, they expect you to pay tax on your basement apartment.

The flip side of this is that the IRS keeps reported tax activities confidential. They only share what is required (for example, your taxable income with your state). You can read the details in their disclosure laws.

Deductions will work just as they would if your apartment was perfectly legal. In the eyes of the IRS, whether your income is legal or not is none of their business. They care only about whether it is being taxed appropriately.

They will not share any information with your zoning authority without a court order.

  • Ah, okay. Thank you for the information, that is what I'll do then. Do you think I should tell the accountant that the apartment is illegal or not? – Phil Aug 4 '17 at 13:06
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    My favorite IRS quote ever: “Illegal activities. Income from illegal activities, such as money from dealing illegal drugs, must be included in your income on Form 1040, line 21, or on Schedule C or Schedule C-EZ (Form 1040) if from your self-employment activity.” — Publication 17 – user42405 Aug 4 '17 at 22:05
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    You are required to report the amount of income from illegal activities, so it can be taxed, but you don't have to detail what the activities themselves were, exercising your right against self-incrimination, as what you put on your tax returns can be used as evidence against you in a criminal trial. But in this case not detailing that it's an apartment would likely cause the OP to miss out on some deductions. Reporting it normally as rental income, as this answer suggests, does open the possibility of it being used against you if you're being investigated, though it's unlikely. – user102008 Aug 6 '17 at 6:24
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A basement unit would typically rent for less than similar space on a higher floor. Taxwise, you should be claiming the income, and expenses via schedule E, as if it were legal. Keep in mind, Al Capone was convicted on tax evasion not his other illegal activities. As long as you treat it as a legitimate business, a rental unit, you will be good with the IRS. The local building department will fine you if they find out.

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    Minor nitpick: Al Capone was convicted on tax evasion. Tax avoidance refers to legal strategies to decrease the taxes you need to pay. – Brian Aug 4 '17 at 18:14
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    Thanks for the heads up. Important point. I'm all about tax 'avoidance'. But definitely not 'evasion'. – JTP - Apologise to Monica Aug 4 '17 at 18:17

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