29.7 Personal and Business Use of a Home

If in 2012 you sold a home that was used for business or rental as well as residential purposes, you may be able to exclude part or all of any gain realized on the sale. The excludable amount depends on whether the non-residential and residential areas were part of the same dwelling unit, whether the ownership and use tests (29.2) were met, whether depreciation was allowable after May 6, 1997, and whether the non-residential use was before 2009 or after 2008.

Nonqualified use after 2008.

Gain allocable to periods of “nonqualified” use (not used as principal residence) after 2008 is not excludable from income (29.2), but certain nonresidential periods are excluded from the definition of nonqualified use. For example, renting your home after you (and your spouse) move out is not nonqualified use if the rental occurs within the five-year period ending on the date of sale (see Example 2 in 29.2).

Law Alert

Nonqualified Use After 2008 May Limit Exclusion

Unless an exception applies (29.7), any period after 2008 that a home is not used as your principal residence is considered a period of “nonqualified use,” and gain allocable to the nonqualified use is taxable, even if the two-year residential use test for an exclusion is otherwise met (29.2).

- - - - - - - - - -

As discussed below, the IRS has indicated in Publication 523 that home office use after 2008 is not considered nonqualified use.

Home office within your principal residence.

The IRS takes the position that gain does not have to be allocated between the residential and business use portions of your home where both are within the same dwelling unit. This rule allows a home office to be considered residential property for purposes of the home sale exclusion. If the two-out-of-five-year ownership and use test (29.2) is met for the residential portion, you are also treated as meeting the two-year residential use test for the home office even if you used the area as a business office for your entire period of ownership. As a result, the gain on the entire residence is eligible for the exclusion, except for the gain equal to depreciation for periods after May 6, 1997. The gain equal to post–May 6, 1997, depreciation is never excludable; it must be reported on Schedule D (Form 1040) as unrecaptured Section 1250 gain (5.3).

The IRS in Publication 523 continues to apply its favorable “same dwelling” position for home offices despite the law barring an exclusion for post-2008 nonqualified use. That is, a home office is not treated as nonqualified use.

Depreciation allowed or allowable.

Under IRS rules, you must reduce your basis (29.6) in the home for purposes of figuring gain on a sale by any depreciation you were entitled to deduct, even if you did not deduct it. Furthermore, you cannot exclude the gain equal to the depreciation allowed or allowable for periods after May 6, 1997. This means that if you were entitled to take depreciation deductions for periods after May 6, 1997, but did not do so, the gain equal to the allowable depreciation is generally not excludable. However, if you have records showing that you claimed less depreciation than was allowable, the IRS will reduce the excludable gain only by the claimed (allowed) depreciation.

Business or rental area separate from your dwelling unit.

If you sell property that was partly your home and partly business or rental property separate from your dwelling unit, and the business/rental use of the separate part exceeded three years during the five years before the sale, the gain allocable to the separate part is not eligible for an exclusion (since the two-year use test (29.2) has not been met) and must be reported as taxable income on Form 4797. This could be the case if you lived in one apartment and rented out other apartments in the same building, you rented out an unattached garage or building elsewhere on your property, your apartment was upstairs from your business, you operated a business from a barn or other structure separate from your business, or your home was located on a working farm. See IRS Publication 523 for reporting details.