Business Use or Rental of Home(p17)

You may be able to exclude gain from the sale of a home you have used for business or to produce rental income if you meet the ownership and use tests.

On May 28, 2004, Amy bought a house. She moved in on that date and lived in it until May 31, 2006, when she moved out of the house and put it up for rent. The house was rented from June 1, 2006, to March 31, 2008. Amy moved back into the house on April 1, 2008, and lived there until she sold it on January 29, 2010. During the 5-year period ending on the date of the sale (January 31, 2005–January 29, 2010), Amy owned and lived in the house for more than 2 years as shown in the following table.

Five-Year Period	Used as Home	Used as Rental
1/31/05 – 5/31/06	16 months
6/01/06 – 3/31/08		22 months
4/01/08 – 1/29/10	22 months
	38 months	22 months

Amy can exclude gain up to $250,000. However, she cannot exclude the part of the gain equal to the depreciation she claimed or could have claimed for renting the house, as explained under Depreciation after May 6, 1997.

William owned and used a house as his main home from 2004 through 2007. On January 1, 2008, he moved to another state. He rented his house from that date until April 30, 2010, when he sold it. During the 5-year period ending on the date of sale (May 1, 2005–April 30, 2010), William owned and lived in the house for more than 2 years. Because it was rental property at the time of the sale, he must report the sale on Form 4797. Because he met the ownership and use tests, he can exclude gain up to $250,000. However, he cannot exclude the part of the gain equal to the depreciation he claimed or could have claimed for renting the house, as explained next.

If you were entitled to take depreciation deductions because you used your home for business purposes or as rental property, you cannot exclude the part of your gain equal to any depreciation allowed or allowable as a deduction for periods after May 6, 1997. If you can show by adequate records or other evidence that the depreciation allowed was less than the amount allowable, then you may limit the amount of gain recognized to the depreciation allowed.

This is the part of any long-term capital gain from the sale of your home that is due to depreciation and cannot be excluded. To figure the amount of unrecaptured section 1250 gain to be reported on Schedule D (Form 1040), you must also take into account certain gains or losses from the sale of property other than your home. Use the Unrecaptured Section 1250 Gain Worksheet in the Schedule D instructions for this purpose.

If you use property partly as a home and partly for business or to produce rental income, the treatment of any gain on the sale depends partly on whether the business or rental part of the property is part of your home or separate from it.

If the part of your property used for business or to produce rental income is within your home, such as a room used as a home office for a business, you do not need to allocate gain on the sale of the property between the business part of the property and the part used as a home. In addition, you do not need to report the sale of the business or rental part on Form 4797. This is true whether or not you were entitled to claim any depreciation. However, you cannot exclude the part of any gain equal to any depreciation allowed or allowable after May 6, 1997. See Depreciation after May 6, 1997, earlier on this page.

Ray sold his main home in 2010 at a $30,000 gain. He has no gains or losses from the sale of property other than the gain from the sale of his home. He meets the ownership and use tests to exclude the gain from his income. However, he used part of the home as a business office in 2009 and claimed $500 depreciation. Because the business office was part of his home (not separate from it), he does not have to allocate the gain on the sale between the business part of the property and the part used as a home. In addition, he does not have to report any part of the gain on Form 4797. But since Ray was entitled to take a depreciation deduction, he must recognize $500 of the gain as unrecaptured section 1250 gain. He reports his gain, exclusion, and the taxable gain of $500 on Schedule D (Form 1040).

The facts are the same as in Example 1 except that Ray was not entitled to claim depreciation for the business use of his home. Since Ray did not claim any depreciation, he can exclude the entire $30,000 gain.

You may have used part of your property as your home and a separate part of it for business or to produce rental income. Examples are:

• A working farm on which your house was located,
• A duplex in which you lived in one unit and rented the other, or
• A store building with an upstairs apartment in which you lived.

You cannot exclude 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 2 years during the 5-year period ending on the date of the sale. If you do not meet the use test for the business or rental part of the property, an allocation of the gain on the sale is required. For this purpose, you must 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. See Example 5, later, for an example of how to do this. You must report the sale of the business or rental part on Form 4797.

In 2006, Lew bought property that consisted of a house, a stable, and 35 acres. He used the house and 7 acres as his main home and used the stable and 28 acres in his business for the next 4 years. He sold the entire property in 2010 at a $10,000 gain. Lew met the ownership and use tests for the house but did not meet the use test for the stable. Since the business part was separate from his home, Lew must allocate the basis of the property and the amount realized between the part of the property he used for his home and the part he used for his business. Lew reports the gain on the business part of his property on Form 4797. He can exclude the gain on the part of the property that was his main home.

In 2005, Mary bought property that consisted of a house, a barn, and 2 acres. Mary used the house and 2 acres as her main home and used the barn in her antiques business. In 2009, Mary moved out of the house and rented it to tenants. She claimed depreciation on the house while renting it in 2009 and 2010. She continued to use the barn in her business. Mary sold the entire property in 2010 for a $21,000 gain. Since the barn is separate from her home, Mary must allocate the basis of the property and amount realized between the residential and business parts of the property. She reports the entire gain from the barn on Form 4797 since she did not meet the use test for the barn. She must also report gain on the home to the extent of the depreciation she claimed for the rental.

If you used a separate part of your property for business or to produce rental income in the year of sale, you should 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. You must report the sale of the business or rental part on Form 4797.

To determine the amounts to report on Form 4797, you must divide your 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. In the same way, if you qualify to exclude any of the gain on the business or rental part of your property, also divide your maximum exclusion between that part of the property and the separate part used as your home. If you use Worksheet 2 (near the end of this publication) to figure your exclusion and taxable gain from each part, fill out a separate Part 2 of the worksheet for each.

You generally can exclude gain on the part of your property used for business or rental if you owned and lived in that part as your main home for at least 2 years during the 5-year period ending on the date of the sale. If you used a separate Worksheet 2, Part 2, to figure the exclusion for the business or rental part, fill it out only through line 9. Then fill out Form 4797. Enter the exclusion for the business or rental part on Form 4797 as explained in the Form 4797 instructions. (Also see Example 5, on this page.)

If you have any taxable gain due to depreciation, first fill out the Unrecaptured Section 1250 Gain Worksheet in the Schedule D (Form 1040) instructions. Enter the result on Schedule D. To figure your tax, complete the Schedule D Tax Worksheet in the Schedule D instructions (do not use the Qualified Dividends and Capital Gain Tax Worksheet in the Form 1040 instructions).

In January 2006, you bought and moved into a 4-story townhouse. In December 2008, you converted the basement level, which has a separate entrance, into a separate apartment by installing a kitchen and bathroom and removing the interior stairway that led from the basement to the upper floors. After you completed the conversion, your townhouse had a rental unit that was separate from the part of your house used as your home. You lived in the first, second, and third levels of the townhouse and rented the basement level to tenants until December 2010. You claimed depreciation of $2,000 for the basement apartment. You sold the entire townhouse in December 2010 for a $16,000 gain. Your records show the following.

Purchase price	$ 96,000
Improvements (kitchen and bath in rental)	4,000
Depreciation (on rental)	2,000
Selling price	124,000
Selling expenses	10,000

Because you met the ownership and use tests for both the rental apartment and your residence, you can claim an exclusion for both parts. However, because they are separate units, you must allocate your basis, selling price, and selling expenses between them. You start by finding the adjusted basis of each part. You determine that three-fourths (75%) of your purchase price was for the part used as your home and one-fourth (25%) was for the rental part.

	Home	Rental
	(3/4)	(1/4)
Purchase price	$72,000	$24,000
Plus: Improvements	-0-	4,000
Minus: Depreciation	-0-	2,000
Adjusted basis	$72,000	$26,000

Next, to figure the gain on each part, fill out a separate Part 1 of Worksheet 2 for each part, dividing your selling price and selling expenses between the home and the rental.

		Home	Rental
		(3/4)	(1/4)
Part 1. Gain or (Loss) on Sale
1.	Selling price of home	$93,000	$31,000
2.	Selling expenses	7,500	2,500
3.	Subtract line 2 from line 1. This is the amount realized	$85,500	$28,500
4.	Adjusted basis of home sold	72,000	26,000
5.	Subtract line 4 from line 3. This is the gain or (loss)	$13,500	$ 2,500

Then, to figure your taxable gain and exclusion, fill out a separate Part 2 of Worksheet 2 for each part, dividing your maximum exclusion between the two parts. You are single, so the maximum exclusion is $250,000.

		Home	Rental
		(3/4)	(1/4)
Part 2. Exclusion and Taxable Gain
6.	Depreciation allowed or allowable after May 6, 1997	$   -0-	$ 2,000
7.	Subtract line 6 from line 5	13,500	500
8.	Aggregate number of days of nonqualified use after 12/31/2008	-0-	-0-
9.	Number of days taxpayer owned the property	-0-	-0-
10.	Divide the amount on line 8 by the amount on line 9. Enter the result as a decimal (rounded to at least 3 places). But do not enter an amount greater than 1.00	-0-	-0-
11.	Gain allocated to nonqualified use (line 7 multiplied by line 10)	-0-	-0-
12.	Gain eligible for exclusion. Subtract line 11 from line 7	-0-	-0-
13.	Maximum exclusion	$187,500	$62,500
14.	Exclusion (smaller of line 12 or line 13)	13,500	500
15.	Taxable gain (line 14 minus line 5)	-0-	*
16.	Smaller of line 6 or line 15	-0-	*
* Lines 15 and 16 do not need to be filled out for the rental part.

Do not report the gain from the part used as your home, $13,500, because you can exclude all of it. Report the gain from the rental part, $2,500, in Part III of Form 4797. Enter your $500 exclusion as a loss (in parentheses) on Form 4797, line 2, column (g), and enter "Section 121 exclusion" on that line. Your taxable gain from the rental part is $2,000 ($2,500 – $500).

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 use test for both the business or rental part and the part you use as a home, you do not need to treat the transaction as the sale of two properties. Also, you do not need to file Form 4797. You generally can exclude gain on the entire property.

Assume the same facts as in Example 5, except that in March 2010, you combined the two separate dwelling units by eliminating the basement kitchen and building a new interior stairway to the upper floors. You then used the entire townhouse as your main home for the rest of 2010. Because the entire townhouse was used as your main home for at least 2 years during the 5-year period ending on the date of the sale, you report the gain, $16,000, and the allowable exclusion ($14,000), in Part II of Schedule D (Form 1040). Since your $2,000 taxable gain is from depreciation, it is unrecaptured section 1250 gain; enter it on line 12 of the Unrecaptured Section 1250 Gain Worksheet in the Schedule D (Form 1040) instructions. You have no gains or losses from the sale of property other than the gain from the sale of your home, so you also enter $2,000 on lines 13 and 18 of the worksheet and on line 19 of Schedule D. Then figure your tax using the Schedule D Tax Worksheet.