Cap Gain on Sale When Home is Partial Rental & Primary Residence

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Cap Gain on Sale When Home is Partial Rental & Primary Residence

Ryan Faber
Rental Property Investor · Bentonville, AR · Member since 2015 · 28 posts · 20 votes

I'm selling my house and want to understand the tax implications on the sale, because I have lived in it as well as rented out a portion of it. I've been studying IRS publication 523 and I would like to get some input. Here is my situation:

  • I've owned and lived in my house as my primary residence for 3 years.
  • Up until the last year, I have rented out spare bedrooms (space within the living area).
  • I got married about a year ago and my spouse has now been living in the house as her primary residence for 12 months.

Question 1: IRS publication 523 states in the section under Business or Rental Use of Home, "If the space you used for business of rental purposes was within the living area of the home, then your usage doesn't affect your gain or loss calculations. Examples of spaces within the living area include a rented spare bedroom." I am correct to understand that renting out rooms in my house doesn't effect my eligibility for the exclusion?

Question 2: In going through the eligibility test, the only part I think I don't meet is Step 3--Residence, which requires 24 months of residence over the past 5 years. It also states, "Unlike the ownership requirement, each spouse must meet the residence requirement individually for a married couple filing jointly to get the full exclusion." Because my spouse will only be able to claim the house as her primary residence for 12 months am I correct to understand that we don't pass the eligibility test for the full exclusion?

Question 3: If I don't meet the full exclusion, I certainly meet the criteria for a "Work-Related Move," meaning that I would qualify for a partial exclusion. How would I calculate that partial exclusion?

Thanks!

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Ashish AcharyaBusiness Member
CPA, CFP®, PFS · Sarasota, FL · Member since 2017 · 5k+ posts · 3k+ votes
8y

@Ryan Faber , 

Not to confuse you. I will make this simple. 

1) I would like to kindly disagree with @Joe Splitrock  and @Frank Chin . You do not have to exclude the portion of the house for the capital gain. Entire gain is qualified for the capital gain exclusion. What you read in the pub is correct. You have to exclude the gain only if the rented space was separate dwelling unit ( duplex). If you rented a bedroom out of the house, you qualify for entire sale exclusion. 

2) You will qualify for 250k exclusion. Your wife does not so no 500k, Only your portion. hope the gain is below 250k. 

3) However, you have to recapture the depreciation you took on the rental portion of the house. This is the depreciation you have taken so far time 25%. 

I dont think you have to worry about partial exclusion. 

So, the only tax you will pay is Deprecation * 25%. 

good luck. 

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  • Frank Chin
    Investor · Bayside, NY · Member since 2017 · 1k+ posts · 1k+ votes
    8y

    I owned and lived in duplexes and triplexes where I lived in part and rented out part.

    On the incomes taxes, the owner occupied part is not included in the schedule E. For a triplex,  one third of the property taxes is allocated to the owner portion.

    The rental portion is treated as a separate property, depreciated and it's separate expenses allocated to it. 

    On sales, the owner portion has it's own basis, depreciation, capital gains and the rental has it's own basis, depreciation and gains. The owner portion is enjoys homeowner capital gain exclusion, the rental portion does not.

    So it all depends on how you prepared the taxes for the last three years. If you didn't separate out the rental portion to the schedule E, then you have the whole thing already treated as owner occupied.

    As to your spouse. Is the home under your name? If you owned it the whole time, the exclusion would accrue to you.

    Still, with these issues, I would have a professional tax accountant prepare it. I have a finance degree and on took courses in real estate taxation, and still use a preparer to double check what I did, have him sign off on my returns as preparer. I have LLC's S-Corps and one time a C-Corp, and I can't claim to be up to date on all tax laws, which CPA's have to be, and have them explain my returns if something goes wrong, particularly if they sign off as preparer.

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  • Ryan Faber
    OP
    Rental Property Investor · Bentonville, AR · Member since 2015 · 28 posts · 20 votes
    8y

    @Frank Chin, that makes sense. The part that I'm caught up on is that in IRS Publication 523, page 11, it says the following, which is where I think my situation is a little different because I rented out bedrooms rather than units in a X-plex:

    The home is under my name, but we were planning on filing jointly. That is where we don't meet the residence requirement.

    Looking at the partial exclusion, based on the residence requirement of each living in the residence for 24 months I calculated this:

    (24 months[me] + 12 months[spouse])/(48 months) = 75% partial exclusion = .75*$500,000 (married filing jointly) = $375,000 exclusion

    Am I thinking along the right lines? And yes, I will have my tax professional go over it. He just hasn't done exclusions on partial rentals within the living area before, so I was trying to wrap my head around it ahead of time since this will be on my 2018 return.

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  • Joe SplitrockPro Member
    Moderator
    Rental Property Investor · Sioux Falls, SD · Member since 2015 · 9k+ posts · 18k+ votes
    8y

    @Ryan Faber in question 3 what they mean by full exclusion is to get the $500K worth of exempt capital gains when married filing jointly. On a single basis you are eligible for $350K worth of exempt capital gains. Do you expect to sell the property for more than $250K over what you paid for it, if not no worries about this.

    As @Frank Chin mentioned, the portion of your property that was being rented is subject to gains. Lets say the house is 2400 square feet and the room is 240 square feet, then 1/10 of your property was used as a rental. It would only be excluded from capital gains if you occupied that space for 2 out of the last 5 years. The exclusion to capital gains is only for space you occupied. 

    Part of this depends on how you did your taxes in previous years. I assume you filed a schedule E. What did you setup for basis and depreciation on the rented space? If for some reason you didn't claim the income and didn't file a schedule E, then the government would have no idea you rented the space. If you did file the Schedule E for three years, with or without depreciation claimed, you still have to reclaim the depreciation. So with reclaimed depreciation you pay taxes on recapture plus any gain on that 1/10 of your property.

    You should have a CPA handle this - not a pop up one either, go to a real CPA and have them handle this correctly.

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  • Ashish AcharyaBusiness Member
    CPA, CFP®, PFS · Sarasota, FL · Member since 2017 · 5k+ posts · 3k+ votes
    8y

    @Ryan Faber , 

    Not to confuse you. I will make this simple. 

    1) I would like to kindly disagree with @Joe Splitrock  and @Frank Chin . You do not have to exclude the portion of the house for the capital gain. Entire gain is qualified for the capital gain exclusion. What you read in the pub is correct. You have to exclude the gain only if the rented space was separate dwelling unit ( duplex). If you rented a bedroom out of the house, you qualify for entire sale exclusion. 

    2) You will qualify for 250k exclusion. Your wife does not so no 500k, Only your portion. hope the gain is below 250k. 

    3) However, you have to recapture the depreciation you took on the rental portion of the house. This is the depreciation you have taken so far time 25%. 

    I dont think you have to worry about partial exclusion. 

    So, the only tax you will pay is Deprecation * 25%. 

    good luck. 

    [email protected]941-914-7779
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    3Reply
  • Frank Chin
    Investor · Bayside, NY · Member since 2017 · 1k+ posts · 1k+ votes
    8y
    Originally posted by @Ashish Acharya:

    @Ryan Faber , 

    Not to confuse you. I will make this simple. 

    1) I would like to kindly disagree with @Joe Splitrock  and @Frank Chin . You do not have to exclude the portion of the house for the capital gain. Entire gain is qualified for the capital gain exclusion. What you read in the pub is correct. You have to exclude the gain only if the rented space was separate dwelling unit ( duplex). If you rented a bedroom out of the house, you qualify for entire sale exclusion. 

    2) You will qualify for 250k exclusion. Your wife does not so no 500k, Only your portion. hope the gain is below 250k. 

    3) However, you have to recapture the depreciation you took on the rental portion of the house. This is the depreciation you have taken so far time 25%. 

    I dont think you have to worry about partial exclusion. 

    So, the only tax you will pay is Deprecation * 25%. 

    good luck. 

     I did not say "You do not have to exclude the portion of the house for the capital gain." I said it depends on what his tax return looks like for the last 3 years, i.e. did he have anything down on his schedule E for the rental part? 

    Assumed he had the whole property down as his home, and he mentioned nothing separated out for the rental part. Didn't sound like he did any depreciation either.

    1Reply
  • Ashish AcharyaBusiness Member
    CPA, CFP®, PFS · Sarasota, FL · Member since 2017 · 5k+ posts · 3k+ votes
    8y

    @Frank Chin , 

    Sorry, it was mentioned that you said it, so I said that. 

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    0Reply
  • Ryan Faber
    OP
    Rental Property Investor · Bentonville, AR · Member since 2015 · 28 posts · 20 votes
    8y

    Thanks @Ashish Acharya and @Frank Chin. I did have the rental portion separated on my schedule E, so I think Ashish nailed it with his response. I appreciate the time you've spent answering my question. 

    1Reply
  • Corey Schneider
    Investor · San Diego, CA · Member since 2020 · 12 posts · 4 votes
    2y
    Quote from @Ashish Acharya:

    @Ryan Faber , 

    Not to confuse you. I will make this simple. 

    1) I would like to kindly disagree with @Joe Splitrock  and @Frank Chin . You do not have to exclude the portion of the house for the capital gain. Entire gain is qualified for the capital gain exclusion. What you read in the pub is correct. You have to exclude the gain only if the rented space was separate dwelling unit ( duplex). If you rented a bedroom out of the house, you qualify for entire sale exclusion. 

    2) You will qualify for 250k exclusion. Your wife does not so no 500k, Only your portion. hope the gain is below 250k. 

    3) However, you have to recapture the depreciation you took on the rental portion of the house. This is the depreciation you have taken so far time 25%. 

    I dont think you have to worry about partial exclusion. 

    So, the only tax you will pay is Deprecation * 25%. 

    good luck. 


     Agreed, as I'm going through this myself. Per https://www.irs.gov/publications/p523#en_US_2023_publink1000..., 

    Space within the living area.

    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, which must be recaptured and reported as ordinary income under section 1250(b)(3). Other examples of space within the living area include a rented spare bedroom and attic space used as a home office.

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