by Bob Rywick
In proposed regulations issued in 2000, the Internal Revenue Service said that if a dwelling unit was consistently used partially for residential purposes and partially for business purposes (mixed-use property), only that part of the gain allocable to the residential part would be excludable under the home sale exclusions rules.
In the 2001 edition of Publication 523, the service said that taxpayers who sold a home that was mixed-use property in the year of sale should report the transaction as the sale of two properties. Taxpayers were told to report gain on the sale of the business or rental use part on Form 4797.
The final regulations adopt a more favorable rule from the taxpayer’s standpoint for mixed-use property. Under the final regulations, no allocation of gain is required if both the residential and non-residential parts of the property are within the same dwelling unit. However, even if both parts are within the same dwelling unit, gain to the extent of any post-May 6, 1997, depreciation adjustments is not excludible.
Gain must be allocated if the part of the home for which the use requirement isn’t met is separate from the dwelling unit.
For purposes of the home sale exclusion rules, dwelling unit means a house, apartment, condominium, mobile home, boat, or similar property, but does not include appurtenant structures.
Observation: Thus, the definition of dwelling unit for purposes of the home sale exclusion differs from the definition in Internal Revenue Code § 280A(f)(1) for purposes of the disallowance of certain expenses in connection with the business use of a home, rental of vacation homes, etc. IRC 280A(f)(1) includes appurtenant structures as part of the dwelling unit.
Example 1: Your client, an attorney, bought an eight-room house on Nov. 10, 1999, that she used as her principal residence until she sold it on Feb. 5, 2003. During the entire period that she owned and used it, she used two of the rooms exclusively as a law office, and claimed $8,000 of depreciation on the use of those rooms.
She had a total gain of $120,000 on the sale of the house. Even though one-fourth of the gain is allocable to the two rooms that your client used as her law office, she only pays tax on the $8,000 of her gain allocable to the depreciation taken. This gain is taxed as un-recaptured Section 1250 gain at a maximum rate of 25 percent.
If the rule in the proposed regulations had applied, your client would have been taxed on a gain of $30,000. Of that amount, $8,000 would have been taxed at a maximum rate of 25 percent as un-recaptured Sec. 1250 gain, and $22,000 would have been taxed at a maximum rate of 20 percent as adjusted net capital gain.
Recommendation: If you had clients who reported gain on the sale of the "nonresidence" part of a dwelling unit (other than post-May 6, 1997, depreciation), consider filing an amended return to claim a refund of the tax paid on that gain.
Even if no part of a dwelling unit is being used for business purposes immediately before the sale, gain attributable to post-May 6, 1997, depreciation is still not excludible.
Example 2: The same facts apply as in Example 1 except that your client stopped using part of her house as a law office on August 15, 2001. Gain attributable to depreciation taken between Nov. 10, 1999, and Aug. 15, 2001, is not eligible for the home sale exclusion.
Observation: If in Examples 1 and 2, your client’s law office had been located in a converted detached garage on her property, she would have to treat the sale as two separate transactions and pay tax on the gain allocable to the converted garage.
Allocating gain between residential and non-residential parts of property. For purposes of determining the amount of gain allocable to the residential and non-residential parts of the property, the taxpayer must allocate the basis and the amount realized between the two parts.
Example 3: On June 1, 1997, Your client purchased a property that includes a house, a stable and 50 acres. He has a gain of $50,000 on the sale of the entire property on Feb. 1, 2003. During the five years immediately before the sale, he used the stable and 40 acres for non-residential purposes for more than three of the five years. He used the remaining 10 acres as his principal residence for at least two of the five years. Your client claimed depreciation deductions of $10,000 for the non-residential use of the stable.
Because the stable and the 40 acres used in the business are separate from the dwelling unit, your client must allocate the basis and amount realized between the part of the property that he used as his principal residence and the part that was used for non-residential purposes. You determine that $30,000 of the gain is allocable to the non-residential-use part of the property and that $20,000 of the gain is allocable to the part of the property used as his residence.
Your client must recognize the $30,000 of gain allocable to the non-residential-use portion of the property. Of that amount, $10,000 will be taxed as un-recaptured Sec. 1250 gain at a maximum rate of 25 percent, and $20,000 will be taxed as adjusted net capital gain at a maximum rate of 20 percent. Your client will be able to exclude the $20,000 of the gain that is attributable to the residential use of the property.
Example 4: On July 1, 1997, your client bought property that consisted of a house, a barn and five acres. From July 1, 1997, through Dec. 31, 2000, she used the house and four of the acres as her principal residence. From July 1, 1997, through Jan. 31, 2003, when she sold the entire property, she used the barn and one acre for a furniture business. On Jan. 1, 2001, your client moved out of the house and rented it to tenants from that date until she sold the property.
On Feb. 1, 2003, she sells the entire property, and has a gain of $100,000 on the sale. She claimed depreciation deductions of $8,000 attributable to the furniture business that she operated during the entire period that she owned the property. She claimed depreciation deductions of $5,000 for the 25-month period (Jan. 1, 2001, through Jan. 31, 2003) that she rented the house.
Since the part of the property used in the furniture business is separate from the dwelling unit, gain must be allocated between the part of the property that was used for business purposes and the part used for residential purposes. You determine that $40,000 of the gain is allocable to the non-residential part of the property and $60,000 is allocable to the part of the property that she used as her principal residence.
Your client must recognize all of the gain of the $40,000 allocable to the non-residential part of the property. Of that amount, $8,000 is un-recaptured Sec. 1250 gain and $32,000 is adjusted net capital gain. Your client must also recognize $5,000 of the $60,000 gain allocable to the residential part of the property as un-recaptured Sec. 1250 gain, i.e., the amount attributable to depreciation deducted during the period that the house was rented.
Your client will be able to exclude $55,000 of the $60,000 gain allocable to the house since she used it as her principal residence for at least two years in the five-year period ending on the date of the sale. This is so even though she had not used it as her principal residence during the 25 months immediately before the sale.
Nonresidential use of a separate dwelling unit. The same building may contain more than one dwelling unit. If it does, only one of the dwelling units can be treated as the taxpayer’s principal residence. On the other hand, a separate dwelling unit can be converted into part of another dwelling unit so that two units become just one.
Example 5: On Oct. 1, 1997, your client bought a townhouse containing a finished basement and two floors above the basement. Immediately after the purchase, your client converted the basement into a separate apartment by installing a kitchen and bathroom and removing the interior stairway that leads from the basement to the upper floors.
After the conversion, the property is treated as having two separate dwelling units. Your client uses the upper two floors as his principal residence and rents the basement level to tenants from Jan. 1, 1998, through Dec. 31, 2002. He claims depreciation deductions of $10,000 for that period with respect to the basement apartment. Your client has a gain of $50,000 on the sale of the entire property on Feb. 15, 2003.
Since the basement apartment and the upper floors of the townhouse are separate dwelling units, he must allocate the gain between the part of the property that he used as his residence and the part of the property that he used for non-residential purposes.
After allocating the basis and the amount realized between the residential and non-residential parts of the property, you determine that $15,000 of the gain is allocable to the non-residential part and that $35,000 of the gain is allocable to the residential part.
Your client must recognize the $15,000 of gain allocable to the non-residential part. Of that amount, $10,000 is un-recaptured Sec. 1250 gain and $5,000 is adjusted net capital gain. Your client may exclude the $35,000 of gain allocated to the residential part of the property.
Example 6: The same facts apply as in Example 5, except that your client stops renting out the basement at the end of 2000. In January 2001, he incorporates the basement of the townhouse into his principal residence by eliminating the kitchen and building a new interior stairway to the upper floors. From Feb. 1, 2001, until he sells the townhouse on Feb. 15, 2003, your client uses all three floors of the townhouse as his principal residence.
Accordingly, the only gain that he recognizes on the sale of the townhouse is the depreciation taken on the basement during the period that it was rented. The other gain allocable to the basement is excludible since your client used the entire townhouse as his principal residence for at least two years in the five-year period before it was sold.
