Depreciation: The tax law assumes business assets will decline in value due to obsolescence and wear and tear. Therefore, taxpayers are allowed to take an annual deduction called depreciation, which represents the decline in value. If the asset is later sold for more than its depreciated value, any gain attributable to the depreciation is generally taxed at rates higher than the gain would otherwise be taxed.

In addition, the home sale exclusion does not apply to any depreciation taken on the home after May 6, 1997. This means that even if the gain is less than the allowable exclusion, the portion that represents depreciation after May 6, 1997 will still be taxable.

Mixed-Use or Separate Property? When a home that was used entirely or partially for business is sold, the home gain exclusion may be limited and some portion of the business deduction for depreciation may be taxable. How much of the gain is taxable and the amount of gain that is subject to the gain exclusion depends if the business portion was part of the dwelling unit (mixed-use property) or whether it was a separate structure.

  • Mixed-Use Property: When the business use was within the same dwelling unit, no allocation of gain is required between the business portion and the personal (home) use portion. However, any depreciation attributable to periods after May 6, 1997 would be taxable to the extent of any gain. Allowable depreciation reduces the basis of the home.

Example: Jake, a single taxpayer, sells his home for $350,000. He had originally purchased the home for $55,000 and added a room, which cost $25,000 giving him a cost basis of $80,000. He also had an office in the home for which the allowable depreciation before May 7, 1997 was $2,500 and after May 6, 1997 was $3,000. The cost of selling the home was $27,000. He meets the 2-of-5-years tests, making him eligible to exclude gain up to $250,000, except for $3,000, an amount equal to the depreciation claimed after 5/6/97.

Sales Price……………………………....................$350,000
Less Sales Expenses………………….................<27,000>
Cost Basis………………………......80,000
Allowable depreciation……...........<5,500>
Tax Basis……………………………….....................<74,500>
Gain………………………………………....................248,500
Home Sale Exclusion………………….....................<250,000>
Net Gain (losses not allowed–not less than zero)........0
Taxable Amount (depreciation after 5/6/97)…..........3,000

  • Separate Property: When the business use was within a separate structure such as a guesthouse or detached garage, the tax treatment will depend upon whether the separate structure itself meets the exclusion qualification requirements.
     
  • Mixed-Use Property Sales: The IRS has made it quite clear that in a like-kind exchange transaction, the business portion that the exchange of a home can qualify for both the §121 home sale exclusion and §1031 like-kind exchange deferral treatment. This can occur where the property was used as a principal residence and a business consecutively (e.g., use as a principal residence followed by rental of the property) or concurrently (a portion of the home used as a principal residence and a portion used as a home office). Please call this office for addition information regarding how to qualify for the tax deferral of the business portion gain. The sale of mixed use property can create some complicated issues. Clients are advised to review their option with this office prior to initiating a sale.