You have a two-story house with a full basement level that you bought for $120,000 five years ago. You used the entire property as your home for three years. Then you started a home-based business. You closed off the basement level and used it only for business for two years. During those two years you claimed depreciation of $4,000. At the end of the fifth year, while you were still using the basement level for your business, you sold the property for $180,000.
First you would determine the adjusted basis of the portion used as your home and the business portion. Assuming the purchase price is allocated equally by floor, 2/3 would be for your home and 1/3 would be for the basement level used in your business. The basis of your home would be $80,000, and the adjusted basis of the business portion would be $40,000 minus $4,000 depreciation, for a net of $36,000.
Allocating the selling price based on the same proportion would give you $120,000 applicable to your home and $60,000 applicable to business.
The allocated selling price minus the adjusted basis would result in a gain of $40,000 ($120,000 minus $80,000) on the part of the property used as your home, and $24,000 ($60,000 minus $36,000) on the business portion of the property.
From the $24,000 gain on the business portion, you would subtract the $4,000 depreciation claimed since May 6, 1997. (This will be the Unrecaptured Section 1250 Gain). This will leave an excludible gain of $20,000 on the business portion ($24,000 minus $4,000).
Assume your maximum exclusion is $250,000. Since your total gain of $60,000 ($40,000 for home and $20,000 for business) is less, you can exclude your entire gain.
You would not have to report the gain on the sale of the portion of the property you use as your home since you can exclude the entire amount.
You would report the gain from the business part, $24,000, in Part III of Form 4797, and your exclusion of $20,000 on line 2 of Form 4797, leaving you with a taxable gain of $4,000 from the business part of your property.