8678 / Is a taxpayer permitted to exclude gain on the sale of a principal residence used partially for business purposes if the business portion of the property is separate from the taxpayer's dwelling unit?

Example: Joe operates a dock installation business on a small lake. Rather than renting a separate office space, Joe uses a barn located one hundred feet from his home (the "dwelling unit") to store and repair any broken portions of the docks, as well as for general office space. During the past 10 years, the barn has been his place of business and the home has been his principal residence. In year 11, Joe sells the entire property for $360,000. Because the barn he used for his business is separate from his dwelling unit, he must allocate the basis of the property between the barn and the home.³

One way to allocate basis is based on physical size. To illustrate, when Joe acquired the property, the purchase price and basis for the entire property was $300,000. Physically, the home occupies 2/3 of the property and the barn occupies one-third of the property. Thus, based on size, the basis of home should be $200,000 and the basis of the barn should be $100,000. However, as a result of depreciation deductions Joe claimed on the barn, the basis had been decreased to $45,000.

As to the sale of the property in year 11, Joe's overall economic gain is $60,000 ($360,000 selling price less $300,000 original purchase price). Based on the same allocation method described above, the gain should be allocated $40,000 to the home and $20,000 to the barn. As to the gain allocated to the home, since Joe meets the requirements of IRC Section 121, the entire amount of that gain is excluded from gross income.

On the other hand, $20,000 of the gain is attributable to the barn. None of the gain attributable to the barn is excludable pursuant to IRC Section 121. Thus, it is as if Joe sold the barn for $120,000 (allocating 2/3rd of the $360,000 sales price to the barn). In other words, Joe's gain would be computed in the same way as if he had simply sold the barn. Thus, because his basis in the barn is $45,000, Joe's taxable gain would be computed as follows: