Converting a rental to avoid capital gains

Dear Tax Talk,
My wife and I are building a home and a detached garage with an apartment above. We would like to rent out the apartment if the IRS will still allow us to take the capital gains exclusion when we sell the property in two or three years. Will having a rental unit or a home business in the detached apartment disqualify us from the gain exemption? -- Steve

Dear Steve,
If you live in your home for two years, you can exclude from income the gain from its sale: up to $500,000 for a married couple filing jointly and $250,000 for single taxpayers.

If any part of the home was used in business, such as a home office or rental unit, you may not exclude the gain allocable to the portion so used. You could only exclude the gain if you converted the property to solely personal use two years prior to its sale. For example, you could rent the garage apartment for one year and use it personally for two years and you would remove the taint on its sale.

If the apartment was always a rental at the time of the sale, you would have to allocate the selling price between the apartment and the main home. For example, assume you built the home for $100,000 and 10 percent is allocable to the garage apartment for a cost of $10,000. You rent the apartment for three years and you claim $1,000 in depreciation deductions.

You sell the property for $200,000 in year three. Of the selling price, $20,000 is allocable to the apartment, which has an adjusted basis of $9,000. Your gain on the apartment is therefore $11,000 and is taxable. The gain is reported on Form 4797.

Assume alternatively that you rent the apartment for one year and claim $350 in depreciation. After that your child lives in the apartment for two years, and then you sell the home. Since you converted the property back to personal use, you would only pay tax on the $350 in depreciation, since the remainder can be excluded. You can review Internal Revenue Service Publication 523 for more information.