Mixed Use Property: Tax Rules for Owners

A mixed-use property is a single real estate asset that combines both personal and business functions. Common examples include a building with a retail storefront on the ground floor and a residential apartment above, or a duplex where the owner occupies one unit and rents out the adjacent one.

This dual purpose creates unique financial and tax considerations. Understanding the specific nature of a mixed-use property is the first step for an owner to correctly handle its distinct tax obligations and benefits.

Determining Business Use Percentage

Calculating the business use percentage is the foundation for managing a mixed-use property’s tax finances. This figure determines the portion of shared expenses that can be deducted for the business. The most common and IRS-accepted method is based on square footage, which provides a clear allocation between personal and business sections.

To calculate this percentage, measure the total square footage of the property and the specific area used exclusively for business. Dividing the business-use square footage by the total square footage yields the business use percentage. For example, if a 3,000-square-foot building has a 1,200-square-foot commercial space, the business use percentage is 40%.

This percentage is applied to all indirect property costs on your annual tax filings. The square footage method is the standard, and accurate record-keeping of these measurements is important for substantiating your deductions.

Tax Deductions and Depreciation

Once the business use percentage is established, owners can determine their deductible expenses, which fall into direct and indirect categories. Direct expenses are costs that apply entirely to either the business or personal portion of the property. For example, renovating a commercial storefront is a 100% deductible business expense, while remodeling a personal kitchen is a non-deductible personal expense.

Indirect expenses are costs that benefit the entire property, such as mortgage interest, property taxes, insurance, and utilities. These expenses are deductible based on the business use percentage. If the business portion of your property is 40%, you can deduct 40% of your annual property insurance premium.

Another tax benefit for mixed-use property owners is depreciation, which is the annual deduction for wear and tear on the business portion of the property. The personal-use part of a home is not depreciable. The basis for depreciation is the value of the building allocated to business use, as land is never depreciable.

The depreciation schedule depends on the nature of the business use. The business portion is classified as either nonresidential real property, depreciated over 39 years, or residential rental property, depreciated over 27.5 years. If at least 80% of the property’s gross rental income comes from residential units, the entire building can be depreciated over the shorter 27.5-year period.

Tax Consequences Upon Sale

The IRS treats the sale of a mixed-use property as the sale of two separate assets: a personal residence and a business property. This distinction affects how capital gains are calculated. The allocation between the portions is based on the business use percentage used for annual deductions.

For the personal residence portion, owners may qualify for the Section 121 exclusion. This rule allows a taxpayer to exclude up to $250,000 of capital gains, or $500,000 for married couples filing jointly. To qualify, the owner must have owned and used the property as their primary residence for at least two of the five years before the sale.

The business portion of the sale is subject to capital gains tax and depreciation recapture. Depreciation deductions reduce the property’s cost basis, which increases the total gain upon sale. The IRS requires that this accumulated depreciation be “recaptured” and taxed.

This recaptured amount is not taxed at lower long-term capital gains rates but as ordinary income, up to a maximum rate of 25%. For example, if an owner claimed $80,000 in depreciation, that amount must be recaptured and taxed at the 25% rate. This results in a $20,000 tax liability, separate from any other capital gains tax.