Tax Implications of Selling a Home Partly Used for Business
Understand how selling a home used partly for business affects taxes, including gain calculations, exclusions, depreciation recapture, and state tax differences.
Selling a home that was partly used for business can have tax consequences beyond a typical home sale. The IRS treats the business portion differently from the personal-use portion, which affects how gains are taxed and whether exclusions apply. Home office deductions, depreciation claims, and state-specific rules also influence the final tax liability.
Business Use Allocation
When a home has both personal and business use, the IRS requires the sale to be divided accordingly. The percentage allocated to business use is typically based on square footage or the number of rooms used exclusively for work. For example, if a home office occupies 15% of the living space, 15% of the sale proceeds and tax consequences apply to the business portion.
If the home office was used exclusively and regularly for business, the gain on that portion may not qualify for the primary residence exclusion. Mixed-use spaces may receive more favorable tax treatment. A detached structure, such as a garage or studio used solely for business, is treated as a separate asset, meaning any gain from its sale is fully taxable.
Depreciation Recapture Considerations
If depreciation was claimed for the business portion, the IRS requires recapturing that amount upon sale. This means previously deducted depreciation is taxed as ordinary income, up to a rate of 25%. Even if the home qualifies for the residence exclusion, depreciation recapture still applies.
Depreciation must be recaptured regardless of whether the home sells at a gain or loss. For instance, if $10,000 in depreciation was deducted, that amount must be reported as taxable income when the home is sold. If the business use ended years before the sale, past depreciation deductions may still be subject to recapture.
Calculation of Gains or Losses
Taxable gain or loss is determined by the property’s adjusted basis, which includes the original purchase price, plus capital improvements, minus any depreciation claimed. Improvements such as a new roof or upgraded plumbing increase the basis and reduce taxable gain, while depreciation lowers the basis and increases tax liability.
The sale price is allocated between personal and business portions, based on the percentage of space used for business. If the sale price exceeds the adjusted basis, the difference is a capital gain. Losses can only be recognized for the business portion, as personal residence losses are not deductible.
Selling costs, such as real estate agent commissions and legal fees, can be deducted from the sale price before calculating the final gain or loss. If a separate mortgage was tied to the business portion, loan payoff allocations should also be considered.
Exclusion from Gains for Personal Residence
Homeowners may exclude up to $250,000 of capital gains from taxation when selling a primary residence, or $500,000 for married couples filing jointly, if they meet the ownership and use tests. The home must have been the seller’s primary residence for at least two of the five years before the sale. This exclusion applies only to the personal-use portion; gains on the business-use portion may still be taxable.
Temporary absences, such as work relocations or medical stays, do not necessarily disqualify a seller from meeting the residency requirement, provided the home was not rented out. If the home was previously a rental before becoming a primary residence, part of the gain may be taxable under rules introduced by the Housing Assistance Tax Act of 2008.
Potential State Tax Differences
State tax laws may impose additional complexities beyond federal rules. Some states fully tax the business-use portion, including depreciation recapture, without additional exclusions. States like California and New York follow this approach, while states with no income tax, such as Texas and Florida, do not impose additional capital gains taxes.
Residency status at the time of sale determines which state has taxing authority. Some states tax capital gains based on residency, while others tax based on the property’s location. This can require filing tax returns in multiple states. Consulting a tax professional can help navigate state-specific rules and avoid unexpected liabilities.
Recordkeeping Requirements
Thorough recordkeeping is essential when selling a home that had business use. The IRS requires documentation of the purchase price, improvements, depreciation deductions, and tax filings related to business use. Without proper records, deductions may be disallowed, and penalties could apply.
Receipts, invoices, and contracts for capital improvements should be retained to substantiate adjustments to the home’s basis. Depreciation schedules from prior tax returns are particularly important. Floor plans or other proof of business use can help justify tax allocations.
If the home was inherited or received as a gift, additional documentation is needed to establish the basis. Since the IRS can audit returns for up to six years in cases of substantial underreporting, retaining records for at least this period is advisable. Digital copies can help ensure accessibility in case of an audit or future sale.