Attached Rental Units
The IRS makes a distinction between property a taxpayer lives in and property he or she rents out to others, even if both are within the same building. You need to understand this distinction and its tax implications (enlist a tax account and/or attorney).
For example, suppose that you've owned and lived in a home for a number of years. Your house has an attached rental unit that you rent out. You've claimed depreciation deductions for the rental portion of your property on your annual income tax return. Suppose further that the rental unit accounts for about 25 percent of the total living space of the building. When you sell the property, the IRS treats the sale as two separate transactions -- the sale of your primary residence (the 75 percent portion of the property) and the sale of a rental property (the other 25 percent portion of the property). Therefore, 75 percent of your profits are subject to the primary residence capital gains exclusion rules.
As for the profits on the rental portion of the property, you will owe capital gains tax on those profits unless you buy another building with a rental unit that meets the particular requirements that we discuss in the know how to defer your investment property profits section.