Taxpayers Could Claim a Reduced Gain Exclusion on the Sale of their Primary Home Used Partly for Business or Rental.
Gain Exclusion for Home Used Partly for Business or Rental.
When you use a room or the basement of your principal residence as a deductible home office or rent out that space during the entire time you own the home and later you sell the home, the profit on the residential part of your home could qualify for the gain exclusion. The profit on the business or rental part seemingly could not, because it was not used for residential purposes. Fortunately, IRS regulations allow you to treat the entire home as a single property when the residential part and the business or rental part are within the same dwelling unit. In this case, the entire property will qualify for the full $250,000 or $500,000 gain exclusion (whichever applies), if you meet the timing requirements for the residential part. However, there is an exception.
Taxpayers must include in their taxable income any gain up to the amount of depreciation deductions claimed, post-May 6, 1997, for the business or rental usage of the property. If the gain on the sale of the home is long-term, the depreciation on the office or rental is characterized as so-called unrecaptured Section 1250 gain that is subject to a maximum federal income tax rate of 25 percent under current law. This outcome is beneficial given that as the taxpayer you have already reaped some tax savings from the depreciation at your ordinary tax rate and possibly from self-employment taxes.
Illustration 1.
You are taxpayers who file married filing jointly. You use part of your home as a deductible office for your real estate sales business or any business during your entire ownership period. You have claimed $10,000 of depreciation deductions for the office space. You sell the home for a $500,000 profit, including $10,000 attributable to the depreciation write-offs. Assuming you meet all the gain exclusion timing requirements for the residential part of your property, you can exclude $490,000 of gain. The remaining $10,000 is taxable unrecaptured Section 1250 gain from depreciation that is subject to a federal rate of up to 25 percent.
Illustration 2.
The same basic facts apply as in the preceding example. However, this time your office is in a detached building formerly used as a garage. In this case, you must treat the sale of your property as two separate transactions. You, thus, allocate the sales proceeds and tax basis between the detached building and the rest of the property and calculate two separate gains. You cannot exclude the gain from selling the detached building. The gain from the part used as your principal residence is eligible for the gain exclusion privilege, assuming you meet the timing requirements for that part of the property.
Illustration 3.
You converted the basement or garage of your home into a separate rental dwelling unit by installing kitchen and bathroom facilities and a separate outside entrance. When you sell the property, you must treat the sale as two separate transactions. You allocate the sales proceeds and tax basis between the basement or garage and the rest of the property and calculate two separate gains. You cannot exclude the gain from selling the basement or garage. The gain from the part used as your principal residence is eligible for the gain exclusion privilege, assuming you meet the timing requirements for that part of the property. As you see in the illustrations, you should be thoughtful about business or rental usage of space that is not within the same dwelling unit as your principal residence. Specifically, when the amount of gain allocable to the separate business or rental space would be considerable, you may want to avoid any business or rental usage during the two-year period preceding the sale date. That would allow you to pass the two-out-of-five-years use test for the business or rental part of the property, and it would be eligible for the gain exclusion privilege.
Premature Sale of Property Used for Business or Rental.
You could you qualify for the prorated gain exclusion privilege upon a premature sale of a residence used partly for business or rental purposes. You would calculate the prorated gain exclusion as explained earlier and then use the prorated exclusion to shelter otherwise taxable gain, as explained in the preceding discussion of homes used partly for business or rental purposes.
There are three important things to remember: 1.The prorated exclusion deal is available only for a premature sale that is primarily due to (1) a change in a qualified individual’s place of employment, (2) reasons related to a qualified individual’s health, or (3) unforeseen circumstances. 2. The prorated home sale exclusion cannot be used to shelter gain attributable to any post-May 6, 1997 depreciation from business or rental use of the property. 3.When the business or rental part of the property is not within the walls of the same dwelling unit as the principal residence, the prorated gain exclusion can be used to shelter only gain allocable to the residential part of the property. Any profit on the separate business or rental part is fully taxable.
Illustration.
You are unmarried, and you use part of your home as a deductible office for your real estate sales business during your entire ownership period. You have claimed $2,000 of depreciation deductions for the office space, which is not in a separate structure. After owning the home for only 18 months, you sell it for a $150,000 gain, including $2,000 attributable to the depreciation deductions. Your premature sale is primarily for reasons related to your health. You are entitled to a prorated gain exclusion of $187,500 ($250,000 × 18/24). You can shelter $148,000 of your gain ($150,000 – $2,000 from depreciation) with the prorated exclusion. The $2,000 that you cannot shelter is unrecaptured Section 1250 gain from depreciation that is subject to a federal rate of up to 25 percent.
Homeowners should keep receipts of the works performed and expenses incurred that would modify their basis on their homes because your basis could increase by any addition of features that would increase the value of the homes, or by payments, like insurance claims, that would lower your basis. You might need to scan your receipts because some of them fade over time. This is very critical because if your home value is significantly increased, you might need the evidence to prove your basis.
Further reading:
IRC section 121I
RC section 1041(a)
Treas. Reg. section 1.121
Treas. Reg. section 1.121-1(e)
Treas. Reg. section 1.121-4(b)(2)
IRS Publication 523
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