When You Rent Out Your Home

When you have rented out your main home for a period of time and you subsequently sell it, you can still exclude all or part of the gain provided you meet the ownership and use tests.  In order to meet these tests you must have owned the home for at least two years and lived in the home as your main home for at least two years of the last five years.  You could normally exclude the gain up to $250,000, or up to $500,000 if you are married filing jointly.  But the depreciation you claimed or could have claimed for the period you rented out your home has to be included in your taxable income and cannot be excluded.  In general, if you used your home partly for business or as rental property, the depreciation that was allowed or allowable for the period after May 6, 1997 cannot be excluded.

Home Used Partly for Business or Rental

When you have a property that you use partly as your home and partly for business or rental purposes and you sell the property, the treatment of the gain on the sale will depend partly on whether the business or rental portion of the property was part of your home or separate from your home.  For example, you may have a room in your home that you use as an office or workshop, or you may rent out a room in your house.  This would be considered a business or rental use within your home.  On the other hand, you may have a separate structure on your property that you use for business, such as a garage or barn.

Allocation of Basis and Amount Realized

In some cases it may be necessary to allocate the basis of the property and the amount realized on the sale between the part you use as your home and the part used for business or rental purposes.  You will then be able to determine the amount of gain on each part. Provided you meet the ownership and use tests, you can exclude the portion of the gain that corresponds to your home, and you would report the portion of the gain that corresponds to the business or rental part on Form 4797, Sales of Business Property.

Business or Rental Part Within Your Home

If the business or rental part is within your home, such as a room you use for a home office, you will not need to allocate your basis and the amount realized on the sale.  And you will not need to file Form 4797 for the portion of the sale corresponding to the business or rental part.  But you will need to include any depreciation you have claimed or could have claimed as a deduction on the business or rental part after May 6, 1997 in your taxable income.

For example:

• You owned your home and lived in it as your main home for the last four years.
• You have a room in your home that qualified as a home office for tax purposes.
• You claimed total depreciation deductions of $2,000 for business use of your home, for your home office.
• You sold your home for a gain of $120,000.

You meet the ownership and use tests, so you can exclude the gain on the sale.  Since your home office was inside your home, and not separate from it, you do not need to allocate the basis and the amount realized on the sale between the personal and business portions of your property.  But you cannot exclude the part of the gain equivalent to the $2,000 of depreciation deductions you have claimed.  You would report the entire gain of $120,000 on Schedule D.  Your exclusion would be $118,000, and you would report $2,000 as a taxable gain.

Business or Rental Part Separate from Home

If you have a property where the business or rental part is separate from the part you use as a home, you may have to allocate the basis and the amount realized on the sale.  You would have to make this allocation if you did not meet the use test, that is, you did not use the business or rental part as your main home for at least 2 of the last 5 years.  Some examples of these separate uses of your property include a farm on which your home is located, or an apartment building in which you live in one apartment and rent out the others.

When You Do Not Meet the Use Test for the Business or Rental Part

In order to qualify for the exclusion of gain on the sale of your home, you have to meet both the ownership and use tests.  If you do not use a portion of your property as your main home, you do not meet the use test for that part of the property and therefore cannot exclude a gain on the sale.  If you sell the whole property, you will have to allocate the basis and the amount realized on the sale between the part you used as your home and the part you used for business or rental purposes.

For example:

• You bought a property that has a house and a barn.
• You lived in the house as your main home for three years and used the barn for your business.
• You sell the property at a gain.

You would have to allocate the basis and the amount realized on the sale of the property between the house and the barn.  The gain applicable to the barn would have to be reported on Form 4797.  You could exclude the gain on the house (up to $250,000 or $500,000).

If in the above example, you lived in your home for at least 2 of the last 5 years, and you also rented it out for a period of time, but continued to use the barn for business, you would still allocate the basis and amount realized on the sale to determine how much of the gain corresponds to the barn.  But you would also have to include in your income the part of the gain that corresponds to depreciation deductions you claimed on the house while you were renting it out.

When You Meet the Use Test for the Business or Rental Part

If you have property, part of which is used as a home and part has been used for business or rental purposes, and you have met the use test for the business or rental part (you used it as your home for at least 2 of the last 5 years), how you treat the gain on the sale of the property depends on how you were using the business or rental part in the year of the sale.

Used for Business or Rental in Year of Sale

If you were actually using it for business or rental purposes the year you sell the property, you will have to treat the sale as two separate sales, one for the business or rental part and one for the part you presently use as your home.  In this case, you would have to divide the selling price, selling expenses, and the basis in the entire property between the part used for business or rental purposes, and the part used as your home.  Then, you would also have to allocate your exclusion amount between the two parts.

Generally you can exclude the gain on the business or rental part if you have met the ownership and use tests for exclusion of gain.  You would report the sale of the business or rental part of the property on Form 4797 and would claim the allocated part of your maximum exclusion on that form.  If you have depreciation allowed or allowable after May 6, 1997 on the business or rental portion, you will need to fill out the “Unrecaptured Section 1250 Gain Worksheet” in the Schedule D instructions, and then use the “Schedule D Tax Worksheet” to figure your tax.

Example – Business Use in Year of Sale

You have a two-story house with a full basement level that you bought for $120,000 five years ago.  You used the entire property as your home for three years.  Then you started a home-based business.  You closed off the basement level and used it only for business for two years.  During those two years you claimed depreciation of $4,000.  At the end of the fifth year, while you were still using the basement level for your business, you sold the property for $180,000.

• First you would determine the adjusted basis of the portion used as your home and the business portion.  Assuming the purchase price is allocated equally by floor, 2/3 would be for your home and 1/3 would be for the basement level used in your business.  The basis of your home would be $80,000, and the adjusted basis of the business portion would be $40,000 minus $4,000 depreciation, for a net of $36,000.
• Allocating the selling price based on the same proportion would give you $120,000 applicable to your home and $60,000 applicable to business.
• The allocated selling price minus the adjusted basis would result in a gain of $40,000 ($120,000 minus $80,000) on the part of the property used as your home, and $24,000 ($60,000 minus $36,000) on the business portion of the property.
• From the $24,000 gain on the business portion, you would subtract the $4,000 depreciation claimed since May 6, 1997.  (This will be the Unrecaptured Section 1250 Gain).  This will leave an excludible gain of $20,000 on the business portion ($24,000 minus $4,000).
• Assume your maximum exclusion is $250,000.  Since your total gain of $60,000 ($40,000 for home and $20,000 for business) is less, you can exclude your entire gain.
• You would not have to report the gain on the sale of the portion of the property you use as your home since you can exclude the entire amount.
• You would report the gain from the business part, $24,000, in Part III of Form 4797, and your exclusion of $20,000 on line 2 of Form 4797, leaving you with a taxable gain of $4,000 from the business part of your property.

Not Used for Business or Rental in Year of Sale

Assuming you have met the ownership and use tests for the entire property (home and business or rental portions) and you were not actually using the business portion of your property for business in the year of sale, but rather were using it as part of your home, you would not have to treat the transaction as the sale of two separate properties.  You would not have to file Form 4797 and could generally exclude the entire gain if it is not more than the maximum allowable exclusion.

Example – No Business Use in Year of Sale

Assume the same facts as in the previous example, except that your business grows to the point where you have to move out of the basement level of your home into a separate property.  You return to using the basement level as part of your home.  That year you sell the property, based on the same terms as previously indicated.

• You would report the entire gain of $64,000 ($40,000 plus $24,000), and your allowable exclusion of $60,000 ($40,000 plus $20,000) on Part II of Schedule D.
• Your taxable gain of $4,000 is due to depreciation claimed when the property was being used for business (after May 6, 1997).  This is unrecognized section 1250 gain, so you would have to enter it in the Unrecaptured Section 1250 Gain Worksheet in the Schedule D instructions.
• If you had no other unrecaptured amounts to report, this amount would go on Schedule D, and you would figure your tax using the Schedule D Tax Worksheet.