Calculating Capital Gains when selling a house.

[pattysamsel63]

Recently I read that if a spare room of a house is rented out this is considered business usage that negatively impacts capital gains exclusion when the house is sold. Basically, I gathered from what the person wrote whom I do not believe is an expert, the percent of square footage of the house rented out would result in a reduction by the same percentage of the amount of profit qualifying for capital gains exclusion. Is there any adjustment that takes into account the years of personal use versus rental use of the same spare bedroom? Would the reduction in the amount of capital gains exclusion recaptured be less if someone only rented the bedroom out for 1 year versus if they had rented the same bedroom out for 10 years? I am unsure if the writer was just oversimplifying her explanation of depreciation recapture that would occur. 

[tagteam]

It might help if you provided more context, such as a link to the post or more specific information as to what the person who posted the response stated.

Regardless, any depreciation that was deducted as a result of business use is essentially excluded from the exemption and is subject to recapture at ordinary income tax rates (up to 25%).

[Opus 17]

I will try to make a very brief example.

Suppose you have a house worth $100,000, and 10% of the house is used for business. The value of the house used for business is $10,000, which must be put in service as a business asset and depreciated over 39 years.  That’s roughly $250 per year. (I am oversimplifying several factors, hopefully my colleagues won’t nitpick me.)

That means that for each year the home is used in business, the business owner deducts $250 of the value of the home as a business expense, reducing their business taxable profit and reducing the amount of business tax they have to pay.  That depreciation also reduces the cost basis of the home.  Cost basis is, roughly speaking, the amount of already-taxed dollars that are invested in something. If you invested $100,000 in the house, and then are taking a $250 per year tax deduction, you must reduce the cost basis of the house.

Suppose you then sell the house for $200,000. Without the business use, you would have $100,000 of capital gain. If you had 10 years of business use, your cost basis would be reduced from $100,000 to $97,500, so your capital gain would be $102,500.  That first $2500 of capital gain is called depreciation recapture, and it is taxable.  Then the remaining $100,000 of capital gains may or may not be taxable depending on whether the person qualifies for the exclusion on their personal home.

To oversimplify even further. Depreciation is an allowance for the value of property that is “used up“ in business. If you sell property for more than you paid for it, then you are recovering the value that you previously claimed was “used up.“ Since you are recovering the value of a previous tax deduction, you have to pay tax on that recovered value. 

Because of concepts like inflation and the future value of money, it is generally best to take the present tax deduction, even if that means paying the same amount of tax back in the future.

[Mike9241]

oversimplified, but simply put, any gain attributable to the amount of depreciation allowed (taken) or allowable (the amount that should have been taken)  is not eligible for the home sale exclusion.  if 5% of the house was rented it's only the depreciation on that 5% that isn't eligible not the whole 5%. 

[pattysamsel63]

Thank you for making that easy to understand.

[pattysamsel63]

Am I right to assume if 5% of the house was rented and therefore depreciation on that 5% isn't eligible, that that would also be adjusted by how much time that 5% of the house was rented out versus used for living purposes by the owner?

[Opus 17]

@pattysamsel63 

First, for a residential rental, the depreciation period is 27.5 years rather than general business use which is 39 years, so that affects the calculation a bit.

Second, when you place property in service as a rental, you are supposed to list it on your tax return and begin keeping accurate records. You must account for all the depreciation that you claimed or could have claimed, even if you didn’t claim depreciation in a particular year because you made a mistake.  Your tax return or your accountant should create a depreciation schedule, that memorialize the amount of depreciation you claimed each year.

When you take property out of service as a rental, you have to delist the property from your tax return and stop claiming depreciation.  Then if you begin renting it again, you have to place the property back in service, potentially with the same or a new adjusted cost basis for depreciation, depending on the circumstances.

Time certainly does make a difference. If you rented a room for 20 years, you will have claimed more depreciation than if you rented the room for two years.  

Over the entire length of time the property was rented, the owner or landlord is supposed to be keeping track of the depreciation.  If you have a completed depreciation schedule, then that is your answer. If you claimed $2136 of depreciation, that is what you report when you sell the property. You pay recapture tax on that amount, and then any capital gains over that amount may be eligible for the exclusion.  We aren’t recapturing 5% of the gain if 5% of the home was rented, we are recapturing the amount of depreciation that was claimed or should have been claimed.  The percentage is just one of the factors used to calculate the depreciation amount.  Other factors include the length of time the space was rented, the original cost of the home, and the cost of any permanent improvements that might have been made to the home. 

If you did not keep track of your depreciation at all, you may want to see an accountant to help you calculate the amount of recapture you will have when you sell the property.

[pattysamsel63]

Thank you. This is very helpful!