Cost basis of owner-occupied duplex with improvements

[Kurt Zarwell]

Hello, I am trying to confirm how the IRS requires me to calculate the cost basis of an owner-occupied duplex for calculating my capital gains. I think I know the answer, but I am also hoping I am wrong because it doesn't seem fair. I sold an owner-occupied property for which I had for about 10 years and made a majority of the improvements to my unit and rented the other unit for basically the entire time I owned it. I imagine this is pretty common.

Publication 523 lays out the method to figure out my gain on the rental use of the home. As a duplex, each unit was completely separate and not connected. My question really only involves how to divide up the improvements to increase my cost basis. On the owner side, I am exempt from capital gains because I will not go above my 250/500K limit.

For the improvements done only to my owner-occupied unit, am I only allowed to add those to the personal (home) side of my cost basis? This seems straight forward at first, but to me, it seems a little unfair when I calculate the cost basis of the rental portion. Obviously the sale price of the property is one number, and not divided up to the relative value of each unit. 

For example, If I sold the property for 500K, and my square footage was 60% owner-occupied, and 40% rental, then my rental portion sale price is 200K. But say I poured 100K in improvements into my unit, then you would expect that I would recapture some of those improvements in the final sale price, so it seems unfair to me that I can only deduct 100K to the proportion of the personal side sale price in calculating my gain. Had I not put the 100K in improvements into the property, my overall sale price would have been lower, and thus the proportion of the sale price for the rental unit would be less (and hence less capital gains). 

Does anyone know if I can apply some other method to calculate my capital gains on the rental portion?

Zeek

[Michael Plaks]

@Kurt Zarwell

Sorry for the delay answering your question. I was too busy laughing at your persistent use of the word "fair" while talking about... taxes, of all things!  :)  

I recommend you follow the excellent advice of @Wayne Brooks: treat your duplex as two properties. Fortunately, you get to allocate both the purchase price AND the sale price using any "reasonable" method, and it will somewhat lessen the tax impact that you fear.

Let's say that the duplex was initially purchased for $200k, and the units were in the same condition. You then allocate $120k (60%) to your personal unit and $80k to the rental. Over 10 years, you added $100k of improvements to your personal unit, so your tax basis in your residence is now $220k. Over the same 10 years, you depreciated $20k of your rental unit, so your tax basis in the rental is now $60k.

Now you're selling the duplex for $500k. However, the units are no longer comparable. Your side is a brand new shining shrine, while the rental remains the dump it was originally, because you neglected it for 10 years - which is unfair, by the way ;). Based either on an appraisal (best) or on your Realtor's opinion (2nd best) or on your own guess (not really the best) - you now allocate $400k of the $500k sales price to your residence, and the remaining $100k to the rental.

Result:

Residence: Capital gain = $400k - $220k = $180k, all excluded from taxation.

Rental: Capital gain = $100k - $60k = $40k, of which $20k is long-term capital gain, and the other $20k is depreciation recapture.

Of course, I over-simplified my example by ignoring complexities of depreciation, improvements to the rental side, closing costs and a number of other factors. But it should give you a general idea.