Home sales after rental, office or nonqualified use

When you sell a home that you previously rented or used for business, two exclusion restrictions can apply. Your exclusion must leave out the amount matching business or rental depreciation deductions claimed or available for time after May 6, 1997. You also cannot exclude the portion of gain allocated to periods of nonqualified use.

You apply these restrictions in a specific order. First, you separate the gain attributable to depreciation covered by the depreciation restriction. Next, you multiply the balance by your nonqualified use fraction to find the additional amount barred from exclusion. You do not include the same depreciation gain in that allocation.

You therefore need to distinguish the periods when you used the property as your principal residence from periods of nonqualified use. You also need to distinguish the gain attributable to depreciation from the gain used in the nonqualified use calculation.

Your entitlement to business or rental depreciation deductions for time after May 6, 1997, makes the matching sale profit ineligible for exclusion, whether you took those deductions or not. The restriction covers depreciation allowed or allowable. You cannot limit the restriction to deductions you actually claimed.

Meeting the ownership and use tests does not remove this restriction. In the IRS example involving Taylor, the ownership and use tests support an exclusion of up to $250,000. If you have the same stated facts, you still cannot exclude the $27,000 of gain equal to the depreciation claimed after May 6, 1997, for renting the house.

You keep this depreciation amount outside the nonqualified use calculation. The IRS directs you to Worksheet 3 to figure the portion of gain allocated to nonqualified use after separating gain attributable to depreciation for periods after May 6, 1997.

Your nonqualified use generally includes periods on or after January 1, 2009, when the property was not the principal residence of you, your spouse or your former spouse. Periods before January 1, 2009, do not count as nonqualified use under this rule.

You calculate the allocation using the aggregate periods of nonqualified use during your ownership divided by your total period of ownership. The denominator is your entire ownership period. The numerator includes only periods that meet the definition of nonqualified use after applying its exceptions.

Before multiplying by this fraction, you subtract the depreciation amount that is already ineligible for exclusion from your sale profit. The portion allocated to nonqualified use is unavailable for the home sale exclusion.

You do not count any portion of the applicable 5 year period after the last date you or your spouse used the property as a principal residence. Your exception starts after whichever principal residence use ended later, yours or your spouse's, and covers only the remaining portion of that 5 year period.

You also exclude qualifying periods when you or your spouse serves on qualified official extended duty in the uniformed services, the United States Foreign Service or the intelligence community. Your exception is limited to an aggregate of 10 years, and qualified official extended duty requires you or your spouse to serve on active duty under a call or order for more than 90 days or an indefinite period, either at a duty station at least 50 miles from the property or while residing under Government orders in Government quarters.

You can also exclude other temporary absences totaling no more than 2 years when they result from a change of employment, health conditions or other unforeseen circumstances specified by the Secretary. The temporary absence exception has both a reason requirement and an aggregate time limit.

These exceptions affect your nonqualified use allocation. Excepted time does not shelter your profit attributable to depreciation deductions taken or available from business activity or leasing after May 6, 1997.

You do not have to use the property as your principal residence on the sale or exchange date for section 121 to apply. In the approved IRS exchange example, the owner rented a former principal residence for less than 3 years after owning and using it as a principal residence for at least 2 years during the preceding 5 years.

If you have the same stated circumstances, the example permits an exclusion under section 121 even though the house is rented when exchanged. The example involves an exchange for a townhouse intended for rental and cash that satisfies both sections 121 and 1031.

You separately apply the exception for periods after your last principal residence use within the applicable 5 year period. You also separately account for depreciation. A period excluded from nonqualified use does not make the associated depreciation gain excludable.

You generally establish the 2 year use requirement through occupancy of the residence. Short temporary absences, including vacations and other seasonal absences, count as periods of use even if you rent the residence during those absences.

You therefore count a qualifying short vacation or seasonal absence as use when applying this occupancy rule. For the nonqualified use allocation, you also apply the separate statutory exceptions for the final portion of the applicable 5 year period, qualified official extended duty and qualifying temporary absences.

Your office use can involve both gain eligible for exclusion and gain attributable to depreciation. In the approved IRS office example, the office and residence are part of a single dwelling unit. The example allows $50,000 of gain allocated to the office to be excluded under section 121.

If you follow that example's stated treatment, you cannot exclude its $30,000 of gain attributable to depreciation deductions. The example applies section 121 before the nonrecognition rules of section 1031 and permits the remaining $30,000 of gain to be deferred under section 1031.

When you convert property held for personal use to rental use, your basis for depreciation is the lesser of its fair market value or adjusted basis on the conversion date. This rule applies when you rent your former home.

You compare both amounts at conversion to determine the depreciation basis. At sale, you must leave profit matching rental depreciation deductions outside your exclusion, counting both deductions taken and those available for time after May 6, 1997.

If you pay special assessments to a condominium management corporation for improvements, you cannot deduct those assessments. You may be able to recover your share of an improvement's cost through depreciation.

For the rental property rules, you use a dwelling unit as a home during the tax year if your personal use exceeds the greater of 14 days or 10% of the days you rent it to others at a fair rental price.

If you use the dwelling unit as a home and rent it for less than 15 days during the year, its primary function is not considered rental. You should not report that activity on Schedule E, and you are not required to report its rental income or rental expenses.

You do not count a day as personal use if you spend it working substantially full time repairing and maintaining the property. This exception does not cover improvements. You can exclude the repair and maintenance day even when family members use the property for recreation that day.

You must divide expenses that cover both rental and personal use. Examples include mortgage interest or heat for the entire house. You can use any reasonable allocation method. The two most common methods use your home's number of rooms or square footage.

You may reasonably allocate some expenses, such as water, by the number of people using them. The method must reasonably divide the expense between your rental and personal use.

When dividing expenses, you count a day rented at a fair rental price as rental use even if you also use the property personally that day. This rule does not apply when determining whether you used the dwelling as a home. You do not count days when the property was available for rent but was not actually rented as rental use.

If you have a net loss on Schedule E, you may need to apply both the limit based on your investment at risk in the rental activity and the special limits on passive activities.

If you or your spouse actively participated in a passive rental real estate activity, you may be able to deduct up to $25,000 of its loss against nonpassive income. After accounting for losses allowed under that exception, you may also be able to offset activity credits against tax on up to $25,000 of nonpassive income.

You are not considered to actively participate if your interest, including your spouse's interest, was less than 10% by value of all interests at any time during the tax year. Active participation is a less stringent requirement than material participation.