If you have a property where the business or rental part is separate from the part you use as a home, you may have to allocate the basis and the amount realized on the sale. You would have to make this allocation if you did not meet the use test, that is, you did not use the business or rental part as your main home for at least 2 of the last 5 years. Some examples of these separate uses of your property include a farm on which your home is located, or an apartment building in which you live in one apartment and rent out the others.
When You Do Not Meet the Use Test for the Business or Rental Part
In order to qualify for the exclusion of gain on the sale of your home, you have to meet both the ownership and use tests. If you do not use a portion of your property as your main home, you do not meet the use test for that part of the property and therefore cannot exclude a gain on the sale. If you sell the whole property, you will have to allocate the basis and the amount realized on the sale between the part you used as your home and the part you used for business or rental purposes.
For example:
You bought a property that has a house and a barn.
You lived in the house as your main home for three years and used the barn for your business.
You sell the property at a gain.
You would have to allocate the basis and the amount realized on the sale of the property between the house and the barn. The gain applicable to the barn would have to be reported on Form 4797. You could exclude the gain on the house (up to $250,000 or $500,000).
If in the above example, you lived in your home for at least 2 of the last 5 years, and you also rented it out for a period of time, but continued to use the barn for business, you would still allocate the basis and amount realized on the sale to determine how much of the gain corresponds to the barn. But you would also have to include in your income the part of the gain that corresponds to depreciation deductions you claimed on the house while you were renting it out.