How do you allocate sale expenses and calculate gain for a property with both rental and primary residence portions, including the impact of depreciation recapture?
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To allocate sale expenses and calculate gain for a property with both rental and primary residence portions—including the impact of depreciation recapture—you must follow a multi-step process that incorporates the requirements of IRC §121, §1250, and related regulations. Here’s a comprehensive breakdown:
1. Determine the Allocation Between Rental and Primary Residence Portions
a. Identify the Portions- If the property consists of physically separate units (e.g., a duplex with one unit rented and one used as a residence), allocate based on the relative fair market value (FMV) or square footage of each portion.- If the rental and residence uses are within the same dwelling unit (e.g., a home office), special rules apply (see below).
b. Allocation Method- The IRS requires that the basis, amount realized (sale price minus selling expenses), and selling expenses be allocated between the residential and rental (or business) portions using the same method as was used for depreciation (typically based on square footage, number of rooms, or FMV at the time of conversion),.
2. Calculate Adjusted Basis for Each Portion
a. Start with Original Cost- Include purchase price, closing costs, and capital improvements.
b. Adjust for Depreciation- For the rental portion, reduce the basis by the total depreciation claimed or allowable during the rental period.- For the residence portion, no depreciation adjustment unless part of the residence was also depreciated (e.g., home office).
c. Other Adjustments- Add capital improvements to the respective portion.- Subtract casualty losses or insurance reimbursements, if any.
3. Allocate Selling Expenses
- Selling expenses (e.g., real estate commissions, legal fees, title insurance) are generally allocated between the rental and residence portions using the same method as for basis and sale price allocation (e.g., by square footage or FMV),.
4. Calculate Gain or Loss for Each Portion
a. For Each Portion:- Amount Realized: (Allocated sale price) – (Allocated selling expenses)- Adjusted Basis: (Allocated original basis + improvements) – (Allocated depreciation)- Gain or Loss: (Amount realized) – (Adjusted basis)
5. Apply Section 121 Exclusion to the Residence Portion
- The IRC §121 exclusion (up to $250,000 single/$500,000 joint) applies only to the gain allocable to the portion used as a principal residence, provided the ownership and use tests are met (owned and used as principal residence for at least 2 of the 5 years preceding the sale),,.
- If the property was used as both a residence and rental, only the gain on the residence portion is eligible for exclusion. The rental portion is not eligible for the exclusion unless it was converted to residence use and the use/ownership tests are met for that portion.
- If the property was converted from rental to residence (or vice versa), and there were periods of "nonqualified use" (e.g., rental use after 2008 and before last use as principal residence), the exclusion is reduced proportionally,.
6. Depreciation Recapture (Section 1250)
- Depreciation Recapture: Any gain attributable to depreciation claimed after May 6, 1997, on the rental (or business) portion must be recognized as unrecaptured Section 1250 gain and is taxed at a maximum rate of 25%. This gain cannot be excluded under Section 121, even if the property was later used as a residence,,,.
- Calculation: The recapture amount is the lesser of (a) the total depreciation taken or allowable, or (b) the gain on the sale of the rental portion.
7. Special Rule for Mixed-Use Within a Single Dwelling Unit
- If the rental/business use was within the same dwelling unit as the residence (e.g., a home office), and the business use did not involve a separate structure, you do not need to allocate gain between the business and residence portions. However, you must still recapture any depreciation claimed for the business use,.
8. Reporting the Sale
- Form 4797: Report the sale of the rental (or business) portion, including depreciation recapture,.
- Schedule D/Form 8949: Report the sale of the residence portion and any gain eligible for exclusion under Section 121,.
9. Example Calculation
Suppose you own a duplex: one unit is your principal residence, the other is rented. You sell the property for $600,000. The original cost was $400,000, with $100,000 in improvements. You allocated 50% to each unit. You claimed $50,000 in depreciation on the rental unit. Selling expenses are $36,000.
Step 1: Allocate Sale Price and Expenses- Sale price per unit: $300,000- Selling expenses per unit: $18,000
Step 2: Calculate Adjusted Basis- Original basis per unit: $200,000- Improvements per unit: $50,000- Rental unit: Subtract $50,000 depreciation → Adjusted basis = $200,000 + $50,000 – $50,000 = $200,000- Residence unit: Adjusted basis = $200,000 + $50,000 = $250,000
Step 3: Calculate Gain- Rental unit: ($300,000 – $18,000) – $200,000 = $82,000- Residence unit: ($300,000 – $18,000) – $250,000 = $32,000
Step 4: Apply Section 121 Exclusion- Residence unit: Up to $250,000 ($500,000 joint) of gain can be excluded if requirements are met. Here, the entire $32,000 is excludable.
Step 5: Depreciation Recapture- Rental unit: Of the $82,000 gain, $50,000 is taxed as unrecaptured Section 1250 gain (max 25% rate). The remaining $32,000 is taxed as long-term capital gain.
Step 6: Reporting- Report the rental unit sale and depreciation recapture on Form 4797.- Report the residence unit sale and exclusion on Schedule D/Form 8949.
10. Summary Table of Steps
- Allocate sale price, basis, and expenses between residence and rental/business portions.
- Adjust basis for each portion (subtract depreciation for rental/business).
- Calculate gain for each portion.
- Apply Section 121 exclusion to the residence portion only.
- Recapture depreciation on the rental/business portion (taxed at up to 25%).
- Report on appropriate IRS forms.
In summary: Allocate sale price, basis, and expenses between the residence and rental portions using the same method as for depreciation. Calculate gain for each portion. Apply the Section 121 exclusion only to the residence portion, and only for gain not attributable to depreciation. Depreciation recapture on the rental portion is taxed at up to 25% and cannot be excluded. Report the sale on Form 4797 (rental/business) and Schedule D/Form 8949 (residence). Careful recordkeeping and correct allocation are essential for compliance and optimal tax treatment,,,,.
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