Sec. 121: Is Home Office to Support Rental Treated Diff. vs. Other Home Business Use?

[Jeff Miller]

I'm trying to reconcile my (50/50) partners historical tax treatment of our mixed-use residential property with mine, among other things. 

She's always had a tax pro, I've always DIY.

A big mistake: I've always done my own bookkeeping and tax prep. I should have focused on books and farmed out tax prep early on to get the hang of things, and a few critical years here and there, at least. Luckily technology has caught up with me, the Q/A format of online tax prep is such that good bookkeeping translates to good tax prep, generally speaking. But I digress

Note  that I am speaking only to my %50 share in use of the building. I presume that the way I apportion the use of my %50 of the property is free to differ from the way she appotions her %50 ownership, should I choose to do so. 

The building has 2 residential units, one flat each: a full unfinished basement: and a full unfinished attic. 

Let's say 1,000ft2 footprint. 2 finished flats 1,000ft2 ea.=2,00ft2, unfinished garage 1,000ft2, unfinished attic 100ft2 

For 4,000ft2 total, to look at it MY historical way, 2,000ft2 total to look at it HER historical way: see the following.

We occupied 1 unit, and rented the other.

*Furthermore, I store business inventory in the basement and attic. and have a "Home Office" in our personal flat to administer the business.*

Historically, SHE looks only at the flats, ie: 2,000ft2. She apportions %50 of expenses to the rental proper @27.5 Yr. period, and %50 to personal: of which 1/6  (16.7%, room basis) she takes off for a Home Office @39 Yr. period.  She ignores the attic and basement. This seems reasonable, and seems to have "passed" WRT professional treatment. 

Her way seems like the wiser move and I might adopt it wholesale. 

But I see a possible problem already. I use my home office to administer the business, whereas she uses it to administer the rental. 

Q1: Is my (business `business home office) use treated differently than her (business to rental home office) use under Sec. 121, if under the same (residential) roof?

Q2: Furthermore, is strictly business use of residential/home property (ie: storage of inventory) treated differently under 121, if under the same (residential ) roof?

If you can flatly state that "Business use proper of the Home" is treated the same way as a "Home Office used to administer a Rental Property' under the same roof, , I guess I'm all set and you need not read further.  If there are some subtleties, please DO read further:

The problem as stated given HER historical treatment is minimal compared to the problem that might arise given MY historical treatment:

I've looked at it on a square footage basis considering the building as having 4,000ft2 total as opposed to her 2,000ft2 total:

(2,000ft2 aprtd. to Business for Garage,  Attic: %50)

+  (200ft2 aprtd. to Home Office: %5)

= 2, 200 aprtd. to Business Total: %55

1,000ft2 aprtd. to Rental:25%

   800ft2 aprtd. to Personal Use: %20

Note that I have put the Home Office and Business aprtt. in parenthesis because historically I have not teased them out. But I could (have).

Under these conditions, if my "Strictly Business" use is treated differently than her "Home Office in support of Rental Activities" use I could be facing HUGE capital gains upon sale that SHE did not experience. 

Q3: (somewhat unrelated): Is there anything stopping me from this 4,000ft2 analysis? Or must I give different weights, or exclude entirely, unimproved spaces?

Q4: (related to Q3) Is there anything stopping us (esp. me) from looking at it as a 2,000ft'2 building, as she has done? Are both methods equally valid? At first glance, the net differences in treating it as a 4,000ft2 property as opposed to a 2,000ft2 are trivial: far more depends on the answers to Q1 and Q2.

Q5 is basically a repeat of Q1 but the stakes are higher: Is all that %55, or at least the %50 I write off for garage and basement, treated differently from her Home Office for capital gains  purposes?

Little background, interesting enough:

My partner filed amended returns for 2001, the year I bought her out (for $367K btw). 

On first pass, she applied Capital Gains to her home office. She ended up with less than $250K available for 121. Not sure I have that figure: 189K comes to mind and makes sense.

Second pass, she excluded C/G on the office. She still ended up with less that $250K Sec. 121: 225K, I think. 

But naturally enough her AGI was reduced by $37,902, there were adjustments to her itemized deduction etc., for $40,732 in taxable income reduction. 

A big deal. I am very concerned I'll end up with far less than $250K under 121 if I pursue my current strategy. 

The tax prep explains as follows:

"Taxpayer reported the sale of an office in home on the original tax return.  According to Final Regs issued Dec. 23, 2002, no allocation of gain is required when both the residential and non-residential portions of the property are within the same dwelling unit. Taxpayer meets this definition...remove the profit (C/G) of office in home.  Depreciation recapture will still be included as a taxable event."

In addition to the questions above, this explanation raises an additional question: 

Q5: What is  a dwelling unit, as opposed to a residential unit? After all, there are 2 residential units but they (and my garage and basement) are under one roof. Does the whole thing count as (one) dwelling unit for purposes of Sec. 121? That's how both of us have been treating the property. We've assumed this legal dilemma  is ignored as immaterial, treating the entire property as a "dwelling unit".

Another point of trivia is that I've only filed about 12 of the last 25 years of taxes. I'm working on those twelve. The plan is to re-compute everything and apply the figures to the unfiled taxes. Compared to the filed taxes, there may be some year-to-year inconsistencies. I'll consider those (filed) taxes separately after doing the unfiled.  It's my understanding I can regard the filed years as having been miscalculated. There may be some adjustments to year over year depreciation and depreciated basis etc., if I've over-deducted in filed years I'll add that to my depreciation and deduct from my depreciated basis.

Actually I may have misphrased that: ultimately I'll have a "correct" depreciated basis, ie: whether I actually depreciated or not, and that figure will be compared to actual depreciation in the filed years. I expect the calculated depreciation will be greater than actual, but if not, I'll report any net overage for recapture. 

All sound reasonable?

Because there's ancient history there I probably won't recompute AGI and submit revised 1040's for the filed years. That's a technical foul I'm sure, but they're only asking for the unfiled years: to cut my workload in half, I'm punting on this question: for now at least, and focusing on basis. Besides, probably without exception, I failed to take legitimate deductions which I would  now fold into a 1040X, resulting in a net tax benefit for me for the filed years.  I can't hope to get much of that back due to statutes of limitations.  I think it's true, however, that the statute of limitations does not apply if I have underestimated AGI. Federal and California State may have different statutes. This is  a grey area for me to explore: later. Maybe. Let's not speak of it now. 

Notably, I sold the whole thing in 2021. It's that sale that prompts me to figure out accurate figures for allowable depreciation,  depreciated basis, and 1031 aspects, among other things. Trying to start out on the right foot with my new property.

My hope and best guess is that business use of a home is treated the same way under 121 regardless as to whether it is used for business proper, or business used in support of rental property. 

Actually that seems so obvious I feel silly for asking. 

But you never know the thinking behind tax code. There are plenty of quirks. It favors home ownership in general: witness that interest on home loans is personally deductible, whereas rent is not. By extension, a home office deduction used to support residential property might be treated differently as opposed to a home office used to support business property: to say nothing of the property used by the business for storage of inventory. 

I've tried informally to "trace" this through tax code, and for my own amusement I may try it again and again until I seem to get it right. But I find tax code even less scrutable than general law, and an answer to my (simple?) question could save me the effort of tracing code. And if I trace, I could certainly make a mistake and end up way off. 

Ultimately, I recognize that I should do the calcs both ways: and which strategy is more advantageous may depend on the ultimate sales price of the property in 2021. It may well be that regardless of how I treat Business Property, overall profit is so high that my Personal Exclusion will cover and realize $250K under 121 regardless. 

But this is speculative, at least until I've gone through the motions of apportioning the sales price : which I think I will save for another day. Nobody is hunting me down for 2021 tax returns, though they are foaming at the mouth, I'm sure:  big doings, from which ~$39K was taken from escrow to cover putative Capital Gains.

Thank you so much for taking the time to read my question in whole or in part. It's wordy but I hope it's an enjoyable read, and  a treatment that will survive to help others with similar questions.

-Jeff