Fractional Exemption Use For Investment Property

Fractional Exemption Use For Investment Property

Fractional Exemption Use For Investment Property Although the primary residence exclusion is normally associated with single family homes, it does apply to other types of living arrangements. Resident-owners of apartment buildings can qualify on a percentage basis.

If the resident-owners meet both the ownership and use tests for the property and have not claimed the exclusion on another property in the past two years, they are able to shield a percentage of the gain on the sale of their apartment building by claiming the primary residence exemption for that portion of the property used as their primary residence. The remaining portion will, of course, be taxed as investment property on the sale.

Example:
Paul owns a four-unit property that consists of a large three-bedroom unit in the front and three smaller units in the rear. Paul lives in the front unit and meets all the other criteria for a main home exclusion. When Paul sells the property, he will be able to allocate a portion of the total gain to his primary residence and take the primary residence exclusion. The question: how much? That depends on how the property taxes for the property have been filed in the past.

Presuming Paul has taken all the available depreciation on the investment property portion of the property, he or his accountant has probably already allocated the portion of the property that represents primary residence and the part that is investment property. If the allocation has not already been made in prior tax returns, Paul will be able to use just about any reasonable allocation method.

On a four-unit property the taxpayer could simply allocate 25 percent (one of the four units) of the property as his main home and the remainder as investment property. On the other hand, if the owner’s unit is 1,800 square feet and the other three units combined equal 1,800 square feet, Paul could allocate 50 percent of the property as his primary residence.

The IRS allows any reasonable allocation; how Paul allocates is crucial in understanding future tax consequences. Herein lies a paradox: On one hand investors usually want to maximize depreciation while the property is operational, so they tend to allocate a higher percentage as investment property; on the other hand, when owner-residents sell the property, they want to claim a higher percentage as primary residence. Remember, the primary residence portion of the gain up to the $250,000–$500,000 limits is tax free. The remaining portion allocated as investment property gain is fully taxable.

Even had an unfavorable allocation been made on prior tax returns, it is possible to back up and refile past tax returns to change the allocation. In the alternative, you can also change the allocation for the current year and wait until the newly allocated portion meets the ownership and use tests as a primary residence. If you are going to change a past allocation, be sure to discuss it with your tax advisor first.