Primary residence

[Pacun]

If, (IF). Married client has a primary residence with a basis of 1million and rents 75% and lives in 25% of the property as his primary home. he makes in rental income $50K, but his taxable rental income is -1000 because of (75% depreciation, utilities, mortgage interest, real estate taxes and other rental deductible expenses) At the end of the 2 years they sell the house for $1.5 M. It is my understanding that they will not have to pay taxes on the gain, neither will they have to report the sales of their primary home or recapture depreciation. Is that right?

[GeneInAlabama]

Is this a trick question?

Gene

[Pacun]

Not at all. I just need clarification. It seems that previous rules forced you to recapture depreciation but current rules don't, but I am not 100% sure.

[OldJack]

Gain upto the amount of depreciation allowed or allowable after May 6, 1997 may not be excluded under code sec. 121 and is therefore taxable. What form it is taxable on depends upon the physical location and access of the rental portion of the home.

Basically, if access is within the personal residence portion it will be reported on 1040 Sch-D, if access is only from outside the residence portion it will be reported on form 4797 subject to ordinary income tax rates if form 4797, line 8, has "Nonrecaptured net section 1231 losses from prior years". Otherwise the gain will flow from 4797 to 1040 Sch-D as "Unrecaptured section 1250 gain".

[Pacun]

Thanks for your reply (ONLY ONE reply I would add).

I think that as long as the rental property is only one structure shared by you and your tenant, you use Schedule D. I asked the question the day before yesterday and yesterday's mail had my answer.

NEW RULES FOR SALE OF RESIDENCE WITH RENTAL USE

General Rule

Generally if the property is used as a principal residence in two out of five years preceding the sale, and the other §121 conditions are met, the exclusion applies to all the gain except the part of the gain attributable to depreciation taken after May 6, 1997.

Mixed-Use Property

If property is mixed-use property (part residential and part rental), and it was not used entirely as a principal residence during the five years preceding the sale, the reporting depends on where the rental use takes place. If the rental use takes place within the dwelling unit – defined as a house, apartment, condominium, mobile home, boat, or similar property, but does not include detached structures [§1.121-1(e)(2)], all of the gain is eligible for the §121 exclusion except the gain attributable to depreciation taken after May 6, 1997.

Example: Arthur used his home as rental property during tax years 1995-1998. During this period, the allowable depreciation was $20,000. The depreciation allowed after May 6, 1997, was $7,500. In 2006, Arthur sold his home for $300,000. His adjusted basis in the property was $150,000. Since Arthur used the entire property as a principal residence for two out of five years prior to the sale, the §121 exclusion applies to the gain. Arthur’s total gain is $150,000 ($300,000 sales price minus $150,000 adjusted basis). Of this amount, $20,000 of the gain is due to depreciation. However, under the §121 rules, only the depreciation taken after May 6, 1997, cannot be excluded. Therefore, Arthur may exclude $142,500 of gain and must report $7,500, the depreciation allowed after May 6, 1997, as unrecaptured §1250 gain.

Since Arthur used his entire home as a residence during the five-year period preceding the sale, the transaction is reported on Schedule D. No portion must be reported on Form 4797.

Since the gain shown on Line 16 (Schedule D) is due to depreciation, this gain is considered unrecaptured §1250 gain. It will be included on Line 19 of Schedule D.

Conversion of Principal Residence to Rental

The fact that the principal residence is rented at the time of sale does not necessarily prevent the gain from being excluded under §121. The gain exclusion depends on whether the taxpayer meets the ownership and use requirements and the one-sale-every-two years test at the time of sale. The depreciation allowed or allowable after May 6, 1997, is not eligible for the §121 exclusion.

Example: On May 14, 1999, Jacey purchased a home for $190,000 that she used as her principal residence until December 31, 2004. Jacey acquired a new residence and converted her former residence to a rental property. On October 1, 2006, she sold the rental home for $250,000, recognizing a gain of $75,000. At the time of sale the depreciation claimed on the rental was $15,000. She still lived in the home she acquired in December 2004.

Even though the property was converted to rental use, it still qualifies as Jacey’s principal residence at the time of sale because:

She owned the property for at least two out of the last five years before the sale;

She occupied the property as her principal residence for at least two out of the last five years ending on the date of sale (October 1, 2002 through December 31, 2004, a period of two years and three months); and

She has not used the §121 exclusion for any residence during the two-year period ending on the date of sale.

Therefore, she can exclude $60,000 ($75,000 - $15,000) of the gain on the sale since it is less than the $250,000 maximum exclusion for a single individual. The $15,000 of the gain attributable to depreciation allowed on the rental after May 6, 1997, is taxable since it is not eligible for the §121 exclusion. This amount would be taxed as unrecaptured §1250 gain.

The $75,000 gain is reported on Part III of Form 4797. On Line 2, Part I of Form 4797, the phrase “Section 121 exclusion” must be written and the gain exclusion amount ($60,000) entered as a loss in column (g).

[OldJack]

For such a quote you need to give us a reference. My only question is with regards to:

>>Since the gain shown on Line 16 (Schedule D) is due to depreciation, this gain is considered unrecaptured §1250 gain. It will be included on Line 19 of Schedule D. <<

What authority says it is unrecaptured §1250 gain when the property at time of sale is §1221 rather than §1250?

[joanmcq]

Its from the pubs.

[Pacun]

Yes, it is from pubs. I only copied and pasted.