Q: Many years ago, we bought a small house on a 2-acre parcel. We lived in it while we built a larger home next door (but on our land).

When the new house was completed, we moved into that home and rented out the small house that we originally lived in. Each house has it own address but both properties are on the same property tax bill.

We are planning on selling the property with both homes soon but wonder how the profit should be reported during tax time. Can we still claim the tax exclusion of $250,000 per person? We have claimed depreciation on the small rental on my tax returns. How do we handle the two homes and how do we decide the ratios? If this small rental will cause us tax headache, should we move back into the smaller house for 2 years?

A: Your question is a great question. In a nutshell, if you sell the two homes as a bundle, you will have to treat the sale similar to the sale of any two-unit building. In many places these two unit buildings are called two-flats or bi-levels.

You have already accounted for the ratios between the two homes by deciding how much depreciation to take on the properties. Your accountant should have this information.

If you do not have these ratios set, you should be able to determine the value of the first home and the value of the land when you bought the property. You also should have records to determine the value of the home you built. Based on this information, you should be able to come up with some basis to decide how much of the property would be allocated to the small home and how much to the large one.

There are other methods for determining this allocation that differ from this one and you can walk through each one of them with your accountant.

When you sell the property you will get a $250,000 exclusion ($500,000 if you’re married) from any gain on the sale of the property. If you own the home with another person who has used the property as their primary residence for at least the last 2 out of the last five years, you each will get the $250,000 exclusion.

But each of you will have to account for the profit from the sale of that portion of the property that was rented – the small home and a portion of the land. You will also have to pay taxes on any recapture of depreciation taken on the small home.

You really will need to sit down with a good accountant to determine what your tax liability will be. If you cease using the small home for investment purposes and resume its use as part of your principal residence, you may be able to exclude claim that the entire property is part of your primary residence. But you may still have to pay tax on the depreciated amount that is recaptured.

Finally, if you decide to keep the property as a rental unit, when you go to sell it you can benefit from the tax provisions that would allow you to defer any payment of any taxes on the sale of the small home by using a 1031 exchange.

The 1031 exchange is named after a provision in the tax code that allows a seller of income producing real estate to sell it and buy a replacement property within a certain time period. The guidelines are strict and must be followed closely. But if you use the 1031 exchange you could sell the property and use a portion of the proceeds from the sale – that portion that is claimed to be part of the small home along with a portion of the sales price for the land – and buy another income producing real estate property without paying any tax on that portion of your sale.

Published: Apr 15, 2005