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Expert Q&A Archive

09/17/2008
Do I need to pay capital gains on the sale of a home if I ran a side business in the home?
"I recently sold my house and have received a 1098 from the title company for the amount of the sale. I had a side business off and on over the last 10 years and claimed a small percentage of my home for office use. Will I need to pay capital gains on the entire profit of the sale, or how will this work on next years taxes?"
Rosemary Ervin, CPA:
expert info »
The law just changed on this subject, effective for sales after January 1, 2009. So if the dwelling is sold before next January, you will follow the rules presently in effect ...

The answer depends on whether you took depreciation when you had the business. Were you just deducting utilities and mortgage interest, real estate taxes, etc? Or did you also take depreciation? If you took depreciation, then you will have to allocate part of the gain to the nonresidential use. If you did not take depreciation, you will be allowed the entire exclusion, $250,000 if single, $500,000 if married filing jointly.

This is rather complicated, so you will probably need to see a tax preparer. Following is an excerpt of the law if the property is sold prior to 1/1/09.....

....if a portion of the property was used for residential purposes and another portion of the property, separate from the dwelling unit, was used for nonresidential purposes, then only the gain allocable to the residential portion is excludible....On the other hand, if both the residential and nonresidential portions of the property are within the same dwelling unit, then allocation of basis and amount realized is not required (and the entire amount of the gain is excludible, provided that the two-year ownership requirement is also satisfied)
The exclusion is reduced to the extent of any depreciation adjustments in connection with the rental or business use of such residence. Depreciation adjustments are defined as all adjustments reflected in the adjusted basis of property for any depreciation allowed or allowable that are attributable to periods after May 6, 1997. To the extent gain is includible in income under the home-sale gain exclusion provision due to depreciation taken, a special maximum capital gain rate of 25% will be applicable.

Example: Taxpayer D, an attorney, buys a house in 2003. The house constitutes a single dwelling unit but D uses a portion of the house as a law office. D claims depreciation deductions of $2,000 during the period that she owns the house. D sells the house in 2006, realizing a gain of $13,000. D has no other capital gains or losses for 2006. D must recognize $2,000 of the gain as unrecaptured 1250 gain...... D may exclude the remaining $11,000 of the gain from the sale of her house because she is not required to allocate gain to the business use within the dwelling unit.

Example: Non-residential use within the dwelling unit, property not depreciated.
The facts are the same as in Example 5, except that D is not entitled to claim any depreciation deductions with respect to her business use of the house. D may exclude $13,000 of the gain from the sale of her house because, under paragraph (e)(1) of this section, she is not required to allocate gain to the business use within the dwelling unit.

Joan Koonce, Ph.D:
expert info »
Normally a person can exclude a certain amount of capital gains on the sale of a home. You have to meet certain criteria, and the amount that you can exclude depends on your filing status. You can exclude up to $500,000 of the gain if you file married filing jointly and up to $250,000 for all other filing statuses. In order to claim the exclusions, the following must apply. During the 5-year period ending on the date of the sale, you must have owned the home for at least 2 years, lived in the home as your main home for at least 2 years, and during the two year period ending on the date of the sale, you did not exclude gain from the sale of another home.

If you owned and lived in the home as your main home for less than 2 years, you can still claim an exclusion in some cases. However, how much you can exclude will be limited. If you used a percentage of your home as a home office, a portion of your capital gains may be taxable. If you claimed a depreciation deduction on your tax returns in the previous years, then any capital gain equal to that depreciation is taxable. Below is an example provided by the IRS on their website that may be helpful.

"Ray sold his main home in 2007 at a $30,000 gain. He has no gains or losses from the sale of property other than the gain from the sale of his home. He meets the ownership and use tests to exclude the gain from his income. However, he used part of the home as a business office in
2006 and claimed $500 depreciation. Because the business office was part of his home (not separate from it), he does not have to allocate the gain on the sale between the business part of the property and the part used as a home. In addition, he does not have to report any part of the
gain on Form 4797. But since Ray was entitled to take a depreciation deduction, he must recognize $500 of the gain as un-recaptured section 1250 gain. He reports his gain, exclusion, and the taxable gain of $500 on Schedule D (Form 1040) "(www.irs.gov).
Rebecca Schreiber CFP:
expert info »
If you had only been claiming the deduction for three years then there would still be two of the last five years for which to qualify for the income exclusion. Since you've been claiming it for 10 years, that part of your home is no longer your primary residence and you would have to pay taxes on the office portion of your home. Talk to your accountant about a 1035 exchange - perhaps you can take the same portion of your new home and make it your office as well and avoid having to pay any taxes at all. Then, when you are no longer using it as an office, you can reclaim that portion of your home as your primary residence and eventually sell tax-free. Good luck!
Gail Rosen, CPA:
expert info »
Good news...the law has changed and you no longer have to pay any capital gains tax on the sale of your home office. The only tax you have to pay on the sale of home is on recapturing the previous depreciation you had taken.
 

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