How does rental activity affect the sale of home exclusion?

Question of the Week 3/17/21: How does a homeowner’s rental activity affect the sale of home exclusion?

March 26, 2021

Q: How does rental use of a home impact the sale of home exclusion?

Matt and Delores

Matt and Dolores are joint filers. They have owned and lived in their home since 2010 and are thinking about selling it this year. From 2011 to 2018 they rented their basement continuously to unrelated tenants. The space has its own small kitchen, bath, separate entrance, etc.

In 2018 they stopped renting it out as they decided they wanted the space for themselves for entertaining, houseguests, etc. They expect gain on their home to be well under $500,000.

Carlos

Carlo is a single taxpayer. He owned his duplex home since 2014 and sold it in 2020. It is a side-by-side structure. He lived in one half of the home and rented out the other half to unrelated tenants for the whole time he owned it.

The property value appreciated considerably since he bought it and gain on the sale is over $250,000.

The clients reported all rental income and expenses, including depreciation, in the years they rented out space in their homes.

How do the rental activities affect the sale of home exclusion for these clients?

A: If the rental portion is a separate space from the personal home dwelling space, realized gain, basis, and sales expenses must be allocated to the two portions of the property.

In general, when a portion of a home is separate from a taxpayer’s dwelling unit, only the gain allocable to the personal residence portion of the property is potentially excludable under §121.

For Matt and Dolores, and for Carlo, parts of their properties were separate from their personal dwelling units and used for rental purposes.

No allocation needed for former rental use space

A separate space in a home that was formerly used for business or rental purposes is treated as residence space if all of the following are true.

The taxpayer:

  • Was not using the space for business or rental at the time the property was sold,
  • Did not earn any business or rental income from the space in the year the property was sold, and
  • Used the space as residence space for the two out of five years leading up to the sale.

Matt and Delores

Applying these criteria to Matt and Dolores, their basement has not been used as a rental apartment for more than two years. Presumably they’ve received no income from it after they stopped renting it.

By the time they sell their home they will have used it as part of their personal residence for more than two years. They do not have to allocate any portion of the gain to the rental activity.

However, the portion of the gain attributable to depreciation is not excludable. Suppose Matt and Dolores sell their home for $400,000, their adjusted basis on the home is $275,000, and they claimed depreciation of $20,000 during the years they rented the basement.

Their gain on the sale would be $125,000 ($400,000 - $275,000). Of that amount, $20,000 must be recognized as unrecaptured §1250 gain, taxed at a maximum rate of 25%.

The remaining $105,000 is excludable under the §121 home sale exclusion rules. However, if they had not rented part of their home at any time, they would exclude the entire $125,000.

Note that Matt and Dolores would have to recognize gain on depreciation even if they had not previously deducted it as the recognition applies to allowed or allowable deprecation.

Taxpayers who are caught by this rule when they sell property can claim catch-up depreciation by filing Form 3115, Application for Change in Accounting Method.

Rental use allocation of sales proceeds, basis, and gain to the rental use portion of the home

For Carlo, only the gain allocable to the residential portion of his duplex is eligible for the exclusion. Adjusted basis, the amount realized from the sale, and sale expenses must be allocated between the two portions of the property.

Some items, such as the sales price, are allocated to the two portions based on rental and personal usage. The percentage used to figure depreciation can be used for this purpose. For instance, suppose that Carlo used 40% as the rental percentage for deprecation and sold the home for $600,000.

He would allocate $240,000 ($600,000 × 40%) to the rental portion of the property and the rest to the personal portion.

Other items may pertain only to one portion or the other. For instance, if Carlo remodeled his personal kitchen the renovation cost would increase basis only on the personal side. Depreciation on the rental must be allocated 100% to the rental side.

Allocation

One way to properly allocate each item is to use Worksheet 2 “How to Figure Your Gain or Loss” in IRS Pub. 523, Selling Your Home. As the publication suggests, have three copies of the worksheet labeled total, rental, and home/personal.

As a guide, complete the “total” worksheet as if the entire property was a personal use property only. Include basis adjustments, cost of improvements, etc. regardless of whether they were business or personal use items.

Then allocate each item on the “total” worksheet to the “rental” and “personal” worksheets.

Gain on the personal residence side is excludable up to $250,000. Gain or loss on the rental side of the property is reported on Form 4797, Sales of Business Property.

See “Is the sale of home exclusion allowed for a property that is used partially for rental?” for more information on selling a personal residence that has business or rental use.

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