Home Sale Taxes: Four Case Scenarios

The Base Facts Used in Each Case:

¹Purchased in 1992

IRC "Section 121" Home Sale Capital Gain Exclusion Amount

• Single Taxpayers               $250,000
• Married Filing Jointly      $500,000

For each of the following cases, let's assume that you purchased your home in 1992 for $100,000. In that sale you "rolled over" an $80,000 capital gain (as per prior tax laws) from your prior home, so the beginning basis in your current home was $20,000. Since the purchase, you have spent $50,000 for capital improvements to the home, increasing the basis to $70,000. Now, you have an offer to sell the house for $350,000.

Let's figure the sale taxes under several different scenarios.

Case 1: Single Taxpayer, No Business Use of Home

Your total capital gain is $280,000 ($350,000 minus your basis in the home of $70,000). As a single taxpayer who has lived in the home for more than two years, you qualify for the $250,000 Section 121 capital gain exemption. Therefore, your taxable gain is $30,000 ($280,000 minus $250,000), and so your home sale taxes total $4,500 (15% federal long-term capital gain rate times the $30,000 capital gain).

Note: If you live in a state that has a capital gains tax, you will also owe a state capital gains tax.

After two years, you can qualify for the exclusion again and exclude up to $250,000 of the gain on the sale of another residence.

Case 2A: Single Taxpayer with Business Use of Home

Let's assume that 20% of your home is used for business purposes, and that over the past 15 years you have deducted $18,000 in expenses (20% of the total cost to heat, cool, power, clean, and insure your home) and depreciation totaling $15,000.

Calculating the home sale tax is a little more complicated in this case because any depreciation taken must first be "repaid" before the calculation of any gain and/or use of any capital gain exclusion. So, to illustrate, the first $15,000 of your $280,000 gain is "used" to repay prior depreciation. That "depreciation recapture" amount is taxed at your ordinary income rate. If we assume that your ordinary income bracket is 25%, you'll owe $3,750 for recapture of prior depreciation taken. Now, let's deal with the $265,000 of capital gain that remains ($280,000 total capital gain less the $15,000 of depreciation recaptured). Applying the $250,000 exclusion for single taxpayers, you will have a taxable capital gain of $15,000, which will be taxed at the long-term capital gain rate of 15% and tax of $2,250. So your total tax bill in this case is $6,000 ($3,750 +$2,250).

Thus, by using your home for business purposes you increased your home sale-related tax bill by $1,500 ($6,000 minus $4,500), because the $15,000 depreciation recapture amount is taxed at 25% instead of 15%. But don't forget that by using part of your home for business purposes you were able to deduct $18,000 in expenses over the past 15 years (and no recapture required on those).

Case 2B: Single Taxpayer with Business Use of a Detached Part of Home

In this case, let's say your "home" has a separate structure - an old servants' quarters, detached garage area or barn - separate from the main structure that you live in. Let's assume that you use that space for a business purpose. In this case, the tax rules are much different.

First, you can't use any of your $250,000 exemption to shelter the business use portion of your property. So let's assume that the separate structure used for business purposes accounts for 20% of the total square footage of improvements on your property (for example, your home is 3,500 square feet and your converted, detached garage is 875 square feet [875/(3,500 + 875) = 20%]).

The 20% business portion of your gain is $56,000, while the 80% personal portion of your gain is $224,000. First, the $15,000 depreciation that you took on the business use of your home on prior business tax returns is recaptured and taxed at your ordinary income tax rate (25%). This results in a tax of $3,750. Next, the remainder of the $56,000 business gain - $41,000 - is taxed at the long-term capital gain rate of 15%, which results in additional taxes of $6,150. Finally, the $250,000 exclusion for single taxpayers is applied to the personal capital gain of $224,000 and you will have no additional tax due. So your total tax bill in this case is $9,900.

Thus, by using a separate portion of your property for business purposes, you increased your tax bill by $5,400 ($9,900 minus $4,500).

Note: If you had not used the separate portion of your property for business purposes for at least two of the five years preceding the sale, or if the portion of your property used for business would have been a part of your dwelling unit (as in Case 2A), as opposed to a separate portion of your property, you would have been able to use the full exclusion. In either case, you still would have had to pay the $3,750 "recapture" tax on the $15,000 you took as depreciation on prior tax returns, but the net savings would have been $3,900 - the amount of the exclusion you were not allowed to use ($26,000 times the 15% long-term capital gains rate).

What to do: Carefully analyze with your accountant the current and future tax effects of writing off part of your property for a business purpose. The trade-off is simply the value of today's tax deductions from the business portion of your property versus the additional future taxes to be paid if and when you sell your home. You and your accountant can work through the math for both scenarios. You may find that your business-use deductions are not worth the potential capital gain and depreciation recapture taxes you will be paying when you sell your home.

Case 3: Married Couple Filing Jointly with No Business Use of Home

Current federal tax law allows married couples to exclude $500,000 of capital gain on the sale of their home, so the entire capital gain of $280,000 is "sheltered" by the $500,000 exclusion. But if this married couple had used the home for business use - as in the facts in Case 2A above - the couple still would be subject to the depreciation recapture of $3,750, but no capital gains tax would be due. Finally, just as a side note, if you used this home for business use as in the facts in Case 2B above, the taxes would be the same as Case 2B - $9,900.

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Armand Paliotta and Kendra Robben provided their expertise for this article. Mr. Paliotta and Ms. Robben are attorneys with Hartzog, Conger, Cason & Neville in Oklahoma City, Oklahoma.