From 2006-2018 we lived in half of duplex and rented other half out. If we sell before end 2020, can we still exclude 50% of the capital gains as our primary residence?

[dave10]

We lived in half of the duplex from 2006 to Jan 2018 and rented the other half out.  In Jan 2018 we moved and rented both sides out for the entire year.  We plan on continuing to rent both sides until we sell the property.  If we sell before Jan 2021, we will still be in the 2-out-of-5 year window to qualify as a sale of our primary residence and, I think, could exclude 50% of capital gains from taxes.

However, are there complications since we now receive rental income from both sides?  Have we lost our primary residence advantage?

From: https://www.irs.gov/pub/irs-pdf/p523.pdf

Page 11: Business or Rental Use of Home

A space formerly used for business is considered residence space if ALL of the following are true.

1. You weren’t using the space for business or rental at the time you sold the property,

2. You didn’t earn any business or rental income from the space in the year you sold your home, and

3. You used the space as residence space for 2 years out of the 5 years leading up to the sale

If I sell the duplex now, then #1 and #2 are false -- We did use our unit's space for rental and we did earn rental income from it.

I found an answer in the forum for a similiar situation:

https://ttlc.intuit.com/questions/4506176-how-to-calculate-capital-gains-for-the-sale-of-a-duplex-wh...) 

The answer seems to say we can still exclude 50% of the sale from capital gains tax, but it seems at odds with Publication 523 above and I don't know how to reconsile the two.

Would we still be able to exclude 50% of the capital gains as our primary residence or not?

[Zbucklyo · Accepted solution]

Treat this as two separate properties.  On the rental side, you pay capital gains tax on the entire gain, including depreciation recapture.  On the part that used to be a personal residence, you can exclude 250k/500k, but pay depreciation recapture from depreciation since it was converted to a rental.

Simplified example.  You purchased the entire structure for 200k, and sell it for 600k, no capital improvements.  Assuming a 50/50 split, you would have a gain of 200k plus depreciation recapture on the rental portion, and a 200k gain plus smaller depreciation recapture on the personal side. Applying the exclusion on this property eliminates the capital gain, but not depreciation recapture.  You can't apply any if the "leftover" exclusion to the rental side.

[dave10]

Okay, thanks, that's very helpful.  We do have them in TurboTax as two separate "properties". We did, however, make capital improvements to the duplex over the years -- repaving the driveway, renovated both kitchens, rebuilt porches, etc.  Would we also need to recapture the depreciation used on our side for these renovations when we sell our "half"?

[Zbucklyo]

The capital improvements should also be split as appropriate, depending on where they were made.  Any portion applicable to the personal side would be added to cost basis of that side.  Then, when that side was converted to a rental, you'd use that cost basis for depreciation without separately depreciating them.

On the rental side, they should have been added as assets and depreciated when added, and depreciation recaptured on sale.

[dave10]

Ugh... that makes sense and I wonder if I split out our personal side correctly this year for taxes.  I started depreciating the FMV of renovations applicable to our personal side, date-of-service starting from the date we rented it.

For example, I determined the FMV of the driveway resurfacing (discounting for wear-and-tear) and started depreciating 50% of that value. 50% of it was already being depreciated for the rented side. And, or course, I've already submitted our taxes so can't go back and easily change that.  Can I continue to depreciate our personal side renovations (now rented) in this way, or did I mess things up?

[Zbucklyo]

If it were me, I'd amend and only have one depreciation schedule for the personal side.  But it probably amounts to the same thing other than the wear and tear piece if you chose 27.5 year depreciation for everything.