How the homesale exclusion applies to a residence used for residential and business (nonresidential) purposes or to produce rental income
As you know, an individual can exclude up to $250,000 ($500,000 for certain joint filers) of the gain from the sale of his principal residence if he has owned and used the residence as his principal residence for at least two years out of the five-year period before the sale. You recently asked whether the amount of the exclusion would be affected if you used a portion of your property for business or to produce rental income.
You can generally exclude some or all of the gain realized from the sale of a home you have used for business or to produce rental income if you meet the two-year ownership and use tests. If you use the property partly as a home and partly for business or to produce rental income, the treatment of any gain on the sale depends on whether the business or rental part of the property is within your home or separate from your home. However, even if you satisfy the two-year ownership and use tests, the exclusion does not apply to any gain due to depreciation allowed or allowable for periods after May 6, 1997, or to any gain allocable to a period of nonqualified use after December 31, 2008. Any gain attributable to depreciation is subject to a maximum tax rate of 25%. A period of nonqualified use, in general, is any period during which the property is not used as the principal residence of the taxpayer or the taxpayer's spouse (or a former spouse).
If the part of your property used for business or to produce rental income is within your dwelling unit (i.e., house, apartment, condominium, etc.), such as a room used as a home office for a business, it's not necessary to allocate gain on the sale of the property between the business part of the property and the part used as a home.
The rules become more complex if a separate part of your home was used for business or to produce rental income. In that case, you have to apply the ownership and use tests separately to each part of the property. For example, you cannot exclude any gain on the separate part of your property used for business or to produce rental income unless you owned and lived in that part of your property for at least two years during the five-year period ending on the date of the sale.
If you do not meet the two-year use test for the business or rental part of your property, an allocation of the gain on the sale is required. For this purpose, you have to allocate the basis of the property and the amount realized upon its sale between the business or rental part and the part used as a home. The allocation is based on the same method of allocation that you used to determine the depreciation deductions for the business portion of the property.
If you used a separate part of your property for business or to produce rental income in the year of sale, you have to treat the sale of the property as the sale of two properties, even if you met the use test for the business or rental part. This allocation requires you to divide the selling price, selling expenses, and basis between the part of the property used for business or rental and the separate part used as your home. Similarly, if you qualify to exclude any of the gain on the business or rental part of your property, you would also divide your maximum exclusion between the business portion of the property and the separate portion used as your home.
If you have used a separate part of your property for business or to produce rental income (though not in the year of sale) but meet the two-year use test for both the business (or rental) part of your home and the residential portion of your home, it's not necessary to treat the transaction as the sale of two properties. In other words, the exclusion would apply to gain other than gain due to depreciation or gain allocable to a period of nonqualified use.
If you have any questions regarding the above discussed topic or any other tax matter, please feel free to give me a call at (562) 698-9891.
Richard Scrivanich, Partner
For Harvey & Parmelee LLP