Revenue Procedure 2005-14: Home Sale Gain Exclusion
Navigate the tax rules for the home sale exclusion when your property had both personal and business use. Learn how the structure of that use impacts your gain.
When a property serves as both a personal home and a place of business, determining the tax implications of its sale can be complicated. Revenue Procedure 2005-14 from the Internal Revenue Service (IRS) addresses these mixed-use situations. This procedure clarifies how to apply the home sale gain exclusion under Internal Revenue Code (IRC) Section 121, which allows homeowners to exclude a significant amount of profit from taxable income when a home has also been used for rental or business activities.
Determining Applicability of the Revenue Procedure
Revenue Procedure 2005-14 applies to home sales that also qualify for the Section 121 exclusion. This tax provision allows a single individual to exclude up to $250,000 of gain and a married couple filing jointly to exclude up to $500,000. To qualify, you generally must have owned and used the property as your principal residence for at least two of the five years before the sale, and these two years do not need to be continuous.
The guidance becomes relevant when a portion of the principal residence is also used for business or to generate rental income. The IRS addresses two distinct scenarios. The first involves business or rental use within the physical structure of the home, such as a spare bedroom used as a home office.
The second scenario involves business or rental activity in a separate structure on the same property, such as a detached guesthouse or a basement apartment with its own entrance and kitchen. The distinction between use within the main home versus a separate structure dictates the method for calculating the taxable portion of the gain.
Calculating Excludable and Non-Excludable Gain
For business activities conducted within the home’s living space, like a home office, the IRS does not require an allocation of the gain between the personal and business use portions. If you meet the ownership and use tests, the entire gain on the sale is eligible for the Section 121 exclusion, up to the allowable limit. The only exception relates to depreciation deductions claimed for the business use portion of the home.
When the business or rental use occurs in a separate structure, you are treated as selling two properties: a personal residence and a business property. You must allocate the financial aspects of the sale, including the sale price, original cost basis, and improvements, between the two portions.
A common allocation method is based on square footage. For example, if a separate rental unit is 25% of the property’s total square footage, you would allocate 25% of the sale price and cost basis to that unit. The gain is calculated separately for each portion, and only the gain from the personal residence portion is eligible for the Section 121 exclusion.
Addressing Depreciation Recapture
Regardless of the business location, the tax treatment of depreciation requires attention. Depreciation is an annual deduction to recover the cost of the business portion of your property. When you sell, any gain resulting from depreciation deductions claimed after May 6, 1997, cannot be excluded under Section 121.
This recaptured amount is taxed at a maximum rate of 25%, which may be higher than standard long-term capital gains rates. This rule applies even if the business use was within the main home and the rest of the gain is fully excludable. The amount of gain you must recognize is equal to the total depreciation you were entitled to claim.
For example, if you claimed $10,000 in depreciation deductions for a home office, the first $10,000 of your gain is depreciation recapture. This amount is taxed at the 25% rate, even if your total gain is less than your maximum Section 121 exclusion. This calculation is separate from determining the excludable gain on the residence.
Reporting the Sale on Tax Forms
The final step is reporting the sale correctly on your federal tax return. If the entire gain qualifies for the Section 121 exclusion and you have no depreciation to recapture, you may not need to report the sale on your tax return at all.
When there is a taxable component, the sale of the personal residence portion is reported on Form 8949, Sales and Other Dispositions of Capital Assets, and the results flow to Schedule D, Capital Gains and Losses. On these forms, you report the total gain and the amount of the exclusion you are claiming.
The business portion of the sale is reported on Form 4797, Sales of Business Property. This form is used to calculate and report any gain from depreciation recapture. Any remaining taxable gain from a separate business unit is also calculated on Form 4797 before being transferred to Schedule D.