Category: Nontaxable Exchanges; Real Estate; Individuals
Subject: Rental House, Sale of
Title: Exclusion of Gain
IRC Sections: 121, 1034
Filename: 1371.html
Date Produced: 06/98

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Background
Taxpayer owns a residence which was used for rental purposes for many years. Taxpayer plans to evict the tenants and use the house as his principal residence for a period of at least two full years. Thereafter, the taxpayer expects to sell the residence at a considerable gain. The residence cost $100,000 and has $30,000 of accumulated depreciation. The residence is now worth $200,000. $2,000 of the $30,000 accumulated depreciation occurred after May 6, 1998. The taxpayer expects to sell the residence for about $225,000 two years hence.

Issue
How much gain can be excluded under Section 121?

Answers
Assuming the requirements of Section 121 are otherwise met, the amount of gain excluded is $157,000 computed as $225,000 selling price less adjusted basis of $70,000 plus $2,000 of depreciation incurred after May 6, 1997.

Discussion
Under pre-1997 law (IRC Sections 1034 and pre-1997 Section 121), special treatment of the gain on sale of a principal residence was available only for the portion of the home used as the taxpayer's principal residence. Any gain attributable to the portion of a home used for business purposes--e.g., home office or rental use-was not eligible for special treatment. This concept survives the change to the present-day $250,000 exclusion under Section 121.

Under old law, rental or other business use of the residence occurring prior to the year of sale was ignored for purposes of Section 1034 if there was no business use of the residence in the actual year of sale. See Revenue Ruling 82-26, 1982-1 CB 114. For purposes of pre-1997 Section 121, business use was ignored if the taxpayer met the three-out-of five year rule with respect to the entire residence. See pre-1997 Section 121(d)(5) and Regulation Section 1.121-5(e).

In this case, the taxpayer will convert the home in question from 100% rental use to 100% use as his principal residence and will meet the two-out-of-five-year rule under current Section 121 with respect to 100% of the residence. Under the concepts applicable to old law, the taxpayer would not have been required to recognize any gain as a result of prior business use.

Current Section 121, however, treats prior business use differently. The exclusion under Section 121 does not apply to the extent of any depreciation claimed after May 6, 1997. Apparently, this is the case notwithstanding the fact that such business use (and hence, such depreciation) predates the conversion to 100% business use.

Section 121(d)(6) provides as follows.

Recognition of gain attributable to depreciation.--Subsection (a) shall not apply to so much of the gain from the sale of any property as does not exceed the portion of the depreciation adjustments (as defined in section 1250(b)(3) ) attributable to periods after May 6, 1997, in respect of such property.

The committee reports and Blue Book explanation repeat the rule without further comment. The words of the statute seem plain enough. As such, it is necessary to recognize gain to the extent of any post May 6, 1997 depreciation even though the taxpayer used the house 100% as his principal residence during the requisite two-year period preceding the sale.