How Are Capital Gains Taxed on Mixed-Use Properties? (w/Examples) + FAQs

When you sell a mixed-use property, you must treat the sale as two separate transactions. The Internal Revenue Service (IRS) views the part you lived in and the part you used for business or rent as distinct assets. You calculate the tax on the gain for each portion separately, applying entirely different sets of rules to each.

The primary conflict arises from a binding procedural rule known as the “allowed or allowable” depreciation standard. This rule, found in U.S. Treasury Regulation § 1.1016-3(a)(2)(i), forces you to reduce your property’s cost basis by the depreciation you were entitled to take on the business portion, even if you never actually claimed the deduction on your tax returns. This creates a larger taxable gain at the time of sale, directly clashing with the tax-free benefits of the primary residence exclusion and often resulting in a surprise tax bill on “phantom income” you never received.

This issue is increasingly relevant, as over 33 million small businesses in the U.S. are home-based, representing more than half of all businesses. Many of these owners will eventually face the complex tax consequences of selling their mixed-use property.

Here is what you will learn by reading this guide:

🏠 How to legally split your property into two separate assets in the eyes of the IRS.
💰 The step-by-step method to calculate your property’s “adjusted basis,” the single most important number for determining your profit.
🚫 How to apply the powerful $250,000 (or $500,000 for couples) home sale exclusion to the residential part of your gain.
💸 The unavoidable 25% tax on depreciation recapture and why you owe it even if you never took a deduction.
✍️ A line-by-line walkthrough of the specific IRS forms you must file to report the sale correctly and avoid an audit.

The IRS Sees Two Properties, Not One: The Mandatory Split

The moment you sell a property that was used for both personal living and business activities, you must mentally and mathematically divide it. The IRS does not recognize “mixed-use” as a single category for a property sale. Instead, you are required to treat the transaction as the sale of two distinct assets: your personal home and your business property.

This separation is not optional; it is a fundamental requirement. The reason is that the tax laws for each portion are polar opposites. The gain on your home might be completely tax-free, while the gain on the business part is fully taxable. A loss on your home is a nondeductible personal expense, but a loss on the business part could be a valuable tax write-off.

The First Critical Step: Allocating Your Property’s Cost Basis

Before you can calculate your profit, you must determine your investment in each part of the property. This investment is known as your “cost basis.” The process of assigning a specific dollar value to the personal and business portions of your property is called allocation, and it is the most critical calculation you will make.

Your initial cost basis is generally the price you paid for the property, plus certain settlement fees and closing costs like title insurance, recording fees, and surveys.¹ This total cost must then be divided. The IRS does not mandate a single method for this, only that your approach must be clear, reasonable, and supportable.²

Common and IRS-accepted allocation methods include:

Square Footage Method: This is the most common approach. You calculate the percentage of the property’s total square footage used for business and apply that percentage to the total cost basis. This works well for a home office or a duplex with similar units.²
Appraisal-Based Valuation: This is the most defensible method. A qualified appraiser determines the Fair Market Value (FMV) of the residential and commercial portions separately. You then allocate your cost basis in proportion to these appraised values.³
Local Tax Assessor’s Valuation: Your local property tax records often break down the assessed value of your property. You can use the ratio from the tax assessor’s valuation to support your allocation.³

A frequent mistake is forgetting to allocate the basis of the land and the building separately. Land cannot be depreciated, so you must first split the total purchase price between the land and the building. Then, you allocate the building’s basis and the land’s basis between their personal and business uses.¹

Your Home’s Superpower: The $250,000/$500,000 Tax-Free Exclusion

One of the most generous provisions in the U.S. tax code is the primary residence exclusion, governed by Internal Revenue Code (IRC) Section 121. This rule allows you to exclude a massive amount of profit from the sale of your main home from your income. For owners of mixed-use properties, this powerful benefit applies only to the gain calculated for the personal residence portion.

Under Section 121, an eligible individual can exclude up to $250,000 of gain.⁵ For most married couples filing a joint tax return, this amount doubles to $500,000.⁷ This means a huge portion of your profit can be received completely tax-free.

Passing the IRS Gauntlet: The Ownership and Use Tests

To qualify for the exclusion, you must pass two simple tests during the five-year period ending on the date you sell the property. The 24 months required for each test do not need to be continuous.⁸

The Ownership Test: You must have owned the home for a total of at least two years (24 months) within the five-year look-back period. For married couples, only one spouse needs to meet this test.⁸
The Use Test: You must have lived in the home as your main home for a total of at least two years (24 months) within that same five-year period. This is where a critical distinction for married couples comes in. To get the full $500,000 exclusion, both spouses must individually meet the two-year use test.⁵

The “Nonqualified Use” Trap That Shrinks Your Exclusion

A major limitation on this exclusion is the “nonqualified use” rule. This rule prevents property owners from converting a long-term rental property into a primary residence for just two years to wipe away decades of investment-related profit tax-free. A period of nonqualified use is any time after January 1, 2009, that you did not use the property as your main home.⁹

If you have periods of nonqualified use, you must calculate the portion of your gain that is not eligible for the exclusion. You do this by creating a fraction: the numerator is the total period of nonqualified use, and the denominator is your total period of ownership. The percentage of gain equal to that fraction is taxable.⁹

However, the law contains a powerful exception. Any period of nonqualified use that occurs after the last day you used the property as your main home is not counted against you, as long as the sale happens within the five-year look-back period. This means you can live in your home for two years, move out, and then rent it for up to three years. If you sell within that three-year window, the rental period does not reduce your available exclusion.⁹

The Tax That Never Sleeps: Depreciation Recapture

While the Section 121 exclusion can eliminate the tax on your home’s appreciation, one part of your gain is never eligible for this benefit: the gain created by depreciation deductions. This tax, known as depreciation recapture, is the government’s way of clawing back the tax benefits you received over the years. It often leads to a tax bill even when the total profit seems to be covered by the exclusion.

Depreciation is an annual tax deduction that allows owners of business or rental property to recover the cost of that property over its useful life.¹⁰ It is a non-cash expense meant to account for wear and tear. For residential rental property, the depreciation period is 27.5 years; for nonresidential (commercial) property, it is 39 years.¹¹

The “Allowed or Allowable” Rule: The Tax You Owe Even If You Never Took the Deduction

The most unforgiving rule in real estate taxation is the requirement to reduce your property’s basis by the depreciation that was “allowed or allowable”.¹² “Allowed” is the amount you actually claimed on your tax returns. “Allowable” is the amount you were legally entitled to claim under the tax code.

The IRS forces you to reduce your basis by whichever amount is greater. This creates a tax trap for uninformed property owners. If you fail to claim depreciation on your rental unit each year, you not only lose that annual tax benefit, but you are still required to calculate your gain at the time of sale as if you had taken it. You end up with the same large taxable gain without ever having enjoyed the yearly deductions.¹²

Unrecaptured Section 1250 Gain: The Unforgiving 25% Tax Rate

The portion of your gain that comes from this basis reduction is called “Unrecaptured Section 1250 Gain.” This gain is not taxed at the favorable long-term capital gains rates of 0%, 15%, or 20%. Instead, it is taxed at a special, higher maximum federal rate of 25%.¹⁴

Crucially, the tax code is absolute on this point: the Section 121 primary residence exclusion cannot be used to offset or eliminate this 25% tax on recaptured depreciation.⁵ This rule applies whether the business use was a separate rental unit or a home office inside your main living space.

Real-World Breakdowns: Three Common Mixed-Use Scenarios

Applying these rules can be confusing. The following scenarios break down the calculations for the most common mixed-use property sales.

Scenario 1: The Home Office Inside Your House

This situation applies when you use a room within your home, like a spare bedroom, exclusively for your business.

The Setup: Richard, a single taxpayer, bought his home 10 years ago for $300,000 and has always lived in it. For the last six years, he used a 150-square-foot spare room (10% of the home) as his office. Using the “regular method” for his home office deduction, he claimed a total of $5,000 in depreciation. He sells the home for $450,000, paying $25,000 in selling costs.

Because the office was within the walls of his home, the IRS treats the sale as a single transaction for calculating the main gain.¹⁵ However, the depreciation recapture is handled separately and cannot be excluded.

Calculation Step	Tax Outcome
Calculate Total Gain	Sale Price ($450,000) – Selling Costs ($25,000) = Amount Realized ($425,000). Original Basis ($300,000) – Depreciation ($5,000) = Adjusted Basis ($295,000). Total Gain = $425,000 – $295,000 = $130,000.
Isolate Depreciation Recapture	The portion of the gain equal to depreciation taken ($5,000) is not eligible for the home sale exclusion. This amount is taxed at the special 25% rate. Tax = $5,000 x 25% = $1,250.
Apply the Home Sale Exclusion	The remaining gain is $130,000 – $5,000 = $125,000. Richard’s available exclusion is $250,000. Since $125,000 is less than his exclusion, this portion is completely tax-free.
Final Tax Bill	Richard’s total federal tax liability from the sale is $1,250. Even though his total profit was well under the $250,000 limit, the depreciation created a taxable event.

Scenario 2: The Owner-Occupied Duplex

This is the classic mixed-use case where the property must be treated as two separate sales.

The Setup: Carmen and David, a married couple, bought a duplex 12 years ago for $500,000. They have always lived in one unit (50% of the property) and rented out the other identical unit (50%). They have properly claimed $90,000 in depreciation on the rental unit. They sell the entire property for $900,000, paying $40,000 in selling expenses.

Here, every number—from the purchase price to the sale price—must be split 50/50 between the personal and rental portions.⁸

Action Taken	Financial Consequence
Calculate Gain on Personal Portion	Basis (50% of $500k) = $250,000. Amount Realized (50% of $860k net sale) = $430,000. Gain = $430,000 – $250,000 = $180,000. This gain is fully covered by their $500,000 exclusion. Tax = $0.
Calculate Gain on Rental Portion	Basis (50% of $500k) = $250,000. Adjusted Basis ($250k – $90k depreciation) = $160,000. Amount Realized = $430,000. Total Gain = $430,000 – $160,000 = $270,000.
Calculate Tax on Rental Portion	The first $90,000 of gain (depreciation recapture) is taxed at 25% = $22,500. The remaining $180,000 of gain is taxed at the long-term capital gains rate (assume 15%) = $27,000.
Final Tax Bill	The total federal tax liability is $0 (personal) + $22,500 (recapture) + $27,000 (capital gain) = $49,500.

Scenario 3: The Rental Property Turned Primary Residence

This scenario shows the interaction between the nonqualified use rule and depreciation recapture.

The Setup: Finley, a single individual, buys a house on January 1, 2015, for $400,000. He rents it out for 6 years (2015-2020) and claims $60,000 in depreciation. On January 1, 2021, he moves in and lives there as his main home for 4 years. He sells it on January 1, 2025, for $750,000 with $30,000 in selling costs.

The total gain must be carved up into three separate pieces: depreciation recapture, gain from nonqualified use, and gain from qualified use.⁸

Period of Use	Tax Treatment of Gain
Total Ownership (10 years)	Total Gain = $720,000 Amount Realized – $340,000 Adjusted Basis = $380,000.
Depreciation Recapture	The first $60,000 of the gain is taxable as Unrecaptured Section 1250 Gain. Tax = $60,000 x 25% = $15,000.
Nonqualified Use (6 years)	The remaining gain is $320,000. The nonqualified use portion is 6/10, or 60%. Taxable Gain = $320,000 x 60% = $192,000. This is taxed at long-term capital gains rates.
Qualified Use (4 years)	The qualified use portion is 4/10, or 40%. Gain eligible for exclusion = $320,000 x 40% = $128,000. This is fully excluded under Finley’s $250,000 limit.

Common Blunders That Inflate Your Tax Bill

Navigating these rules is complex, and several common mistakes can lead to overpaying taxes or facing an IRS audit.

Mistakes to Avoid

Forgetting to Allocate Basis: The most frequent error is treating the property as a single asset. You must allocate the original purchase price, improvements, and selling expenses between the personal and business portions.
Ignoring “Allowable” Depreciation: Many owners who fail to claim depreciation think they are exempt from the recapture tax. This is false. The IRS taxes you on the depreciation you were entitled to take, creating a painful tax on a benefit you never used.
Miscalculating the Use Test for Couples: For the $500,000 exclusion, both spouses must meet the two-year use test. If only one spouse meets it, the maximum exclusion is capped at $250,000.
Applying the Exclusion to the Business Gain: The Section 121 exclusion can only be used for the gain on the personal residence portion. It cannot shelter any gain from the business or rental part of the property.
Using the Wrong Depreciation Schedule: A home office is considered nonresidential property and must be depreciated over 39 years, not the 27.5-year schedule used for residential rental property.¹⁷

Strategic Moves: Do’s, Don’ts, Pros, and Cons

Smart planning can significantly reduce your final tax bill. Your choices during ownership have direct consequences at the time of sale.

The Home Office Deduction: Simplified vs. Regular Method

The IRS offers two ways to calculate the home office deduction. The method you choose has a profound impact on your taxes when you sell.

| Feature | Regular (Actual Expense) Method | Simplified Method |

|—|—|

| Annual Deduction | You deduct the actual business percentage of home expenses, including mortgage interest, taxes, insurance, utilities, and depreciation. | You deduct a flat rate of $5 per square foot, up to a maximum of 300 square feet ($1,500 maximum deduction).18 |

| Recordkeeping | Requires meticulous tracking of all home-related expenses and complex calculations. | Requires only tracking the square footage of the office. No expense tracking is needed. |

| Depreciation | You must calculate and claim depreciation on the office portion of your home. | Depreciation is treated as zero. You do not claim it.12 |

| Consequence at Sale | You must pay the 25% depreciation recapture tax on all depreciation you were allowed or allowable to take. | There is no depreciation recapture tax to pay when you sell the home.12 |

Choosing the simplified method may result in a smaller annual deduction, but it completely eliminates the headache and tax liability of depreciation recapture down the road.

Do’s and Don’ts for Mixed-Use Property Owners

Do’s	Don’ts
Do keep meticulous records of everything: purchase documents, improvement receipts, and past tax returns.	Don’t guess on your basis allocation. Use a supportable method like square footage or an appraisal.
Do consult a qualified tax professional before you list the property for sale to plan strategically.	Don’t forget to separate the cost of land from the building before allocating basis.
Do understand the “allowed or allowable” depreciation rule and claim your deductions annually.	Don’t assume your entire gain is tax-free just because it’s below the $250k/$500k exclusion limit.
Do analyze whether the simplified home office method is better for your long-term tax situation.	Don’t apply the 27.5-year residential depreciation schedule to a home office; it requires a 39-year schedule.
Do properly document the dates you used the property as a rental versus a primary residence.	Don’t try to apply the home sale exclusion to the business portion of the property.

Pros and Cons of Combining Section 121 and a 1031 Exchange

For the ultimate tax strategy, you can combine the home sale exclusion with a Section 1031 “like-kind” exchange. This allows you to take the tax-free cash from your personal residence portion while rolling the proceeds from the business portion into a new investment property, deferring all taxes on that part.²¹

Pros	Cons
Maximum Tax Deferral: Allows you to defer 100% of the capital gains and depreciation recapture tax on the business portion.	Extreme Complexity: This is a highly sophisticated transaction that requires a Qualified Intermediary and strict adherence to IRS rules.
Tax-Free Cash: You can receive the proceeds from the personal residence portion completely tax-free under Section 121.	Strict Timelines: You have only 45 days to identify a replacement property and 180 days to close on it.[22]
Portfolio Growth: Enables you to leverage your entire pre-tax business equity into a new, potentially larger or better-performing investment property.	“Boot” is Taxable: If you receive any cash from the business portion or don’t buy a property of equal or greater value, that portion is immediately taxable.
Estate Planning: You can continue to defer the tax through subsequent 1031 exchanges for the rest of your life.	Personal Use Disqualifies: The replacement property must be held for investment or business use, not for personal use.
Diversification: You can exchange a mixed-use property for a purely commercial or residential rental property.	High Transaction Costs: Involves fees for the Qualified Intermediary, legal advice, and potentially higher closing costs.

Decoding the Paperwork: Your Step-by-Step Guide to IRS Forms

Reporting the sale of a mixed-use property requires a specific sequence of forms to ensure each type of gain is calculated and taxed correctly. The information flows from one form to the next, culminating on your main Form 1040 tax return.

Form 4797: Isolating the Business Gain and Recapture

Your first stop for the business portion of the sale is Form 4797, Sales of Business Property. This form is where the IRS separates different types of business gains.

Purpose: Its primary job in a mixed-use sale is to calculate the taxable gain from the business/rental portion of your property.²³
Part III is Key: You will use Part III of this form to specifically calculate your Unrecaptured Section 1250 Gain. This is the amount of your gain attributable to depreciation, which will be taxed at the 25% rate. The result from this part flows to your Schedule D.

Form 8949: The Detailed Transaction Report

Next, you use Form 8949, Sales and Other Dispositions of Capital Assets. This form acts as a detailed ledger for every capital asset you sell during the year, including both portions of your mixed-use property.

Purpose: It reconciles the amounts reported to you (and the IRS) on Form 1099-S with what you report on your tax return.²⁵ You will likely use two separate lines on this form: one for the personal residence portion and one for the business portion’s capital gain (the part that isn’t depreciation recapture).
Key Columns:
- (d) Proceeds: Enter the sale price for each portion here.
- (e) Cost or other basis: Enter the adjusted basis for each portion here.
- (f) Code: This is where you enter special codes. For the personal residence portion, you will enter code “H” to indicate you are excluding gain from the sale of your main home.²⁸
- (g) Amount of adjustment: For the personal residence line, you will enter the amount of gain you are excluding under Section 121 as a negative number. This tells the IRS why the gain isn’t showing up as taxable income.²⁸

Schedule D: The Final Summary

Finally, all the numbers come together on Schedule D, Capital Gains and Losses. This form summarizes your short-term and long-term gains and losses for the year.

Purpose: It aggregates the totals from all your Forms 8949 and the gain from Form 4797 to calculate your final net capital gain or loss.²⁹
How it Works: The totals from Part I (short-term) and Part II (long-term) of your Form 8949s are carried over to the corresponding lines on Schedule D. The Unrecaptured Section 1250 Gain from Form 4797 is also entered here, ensuring it gets taxed at the correct 25% rate. The final number from Schedule D is then carried to your main Form 1040.

Frequently Asked Questions (FAQs)

What if I have a loss on my main home portion?No, a loss on the sale of your personal residence is not deductible. It cannot be used to offset other capital gains.
How does the simplified home office deduction affect the sale?Yes, it helps significantly. Using the simplified method means depreciation is treated as zero, so there is no depreciation recapture tax to pay when you sell.12
Do I have to allocate basis if my office was just a desk in a room?Yes, if you claimed the deduction. To qualify for the home office deduction, the space must be used exclusively for business. If it qualifies, you must allocate basis to calculate depreciation.31
I never claimed depreciation on my rental. Can I avoid the recapture tax?No, you cannot. The IRS requires you to reduce your basis by the depreciation you were allowed or allowable to take, even if you never claimed it on your tax returns.12
What records do I need to keep?Yes, keep everything. You need purchase and sale closing statements, receipts for all capital improvements, and copies of past tax returns where you claimed depreciation or a home office deduction.
How is the basis of the land handled?Yes, it’s handled separately. You must first allocate the purchase price between the land and the building. Then, you allocate the basis of each part between its personal and business use.1
What if I acquired the property in a 1031 exchange and then made it my home?Yes, a special rule applies. You must own the property for at least five years after the exchange to be eligible to use the Section 121 exclusion.8
Can I exclude gain from a vacation home?No, the Section 121 exclusion applies only to your “main home,” which is the one you live in most of the time. A vacation home does not qualify.8
My spouse and I own the property, but only I lived there for two years. Can we get the full $500,000 exclusion?No, you cannot. To qualify for the full $500,000 exclusion, both spouses must meet the two-year use test. Your maximum exclusion would be limited to $250,000.5
Does the Net Investment Income Tax (NIIT) apply?Yes, it might. The taxable gain from the business or rental portion is considered investment income and may be subject to the additional 3.8% NIIT if your income is above certain thresholds.34
How do I allocate the cost of a shared improvement, like a new roof?Yes, you must allocate it. The cost of an improvement that benefits the entire structure should be allocated using the same reasonable method (e.g., square footage) you used for the original basis.2
What if my property was a home first, then a rental?Yes, you can still qualify. As long as you meet the 2-out-of-5-year tests, you can claim the exclusion. Renting it for up to three years after moving out does not reduce your exclusion.9
Does the 25% recapture rate apply to all depreciation?No, it does not. The 25% rate applies to depreciation on the building (real property). Depreciation on personal property, like appliances, is recaptured at your higher ordinary income tax rate.36
What if the property is in a trust?Yes, it depends on the trust. If it’s a revocable living trust, the standard rules apply. For irrevocable trusts, the rules are much more complex, and you should consult a tax professional.38
Are there state tax implications?Yes, absolutely. This guide covers federal tax only. Each state has its own rules for capital gains, and the tax liability can be substantial. You must consult your state’s specific tax laws.