Capital gains on a duplex

Dear Tax Talk,
I bought a duplex in 1992 for $125,000. I have lived in it until this year and have been taking depreciation on it each year. I owe $70,000 on the first mortgage and recently borrowed $130,000 from the equity to buy a new single home. The duplex is worth around $250,000. 

My question is, what will the tax/capital gains do to me next tax season if I sell it for $250,000 and have a profit of $50,000? Can I flip the $50,000 into the current new home/mortgage and avoid capital gains? 
— David

Dear David,
You’re confusing profit with your net proceeds from the sale. The gain you realize on the sale is the difference between your adjusted basis in the property and the selling price.  The amount of cash you receive does not change your gain. 

I assume you have been depreciating half of the cost of the property for the rental portion of the duplex; the other half should have not been depreciated, as it was your residence. I say half of the unit because I assume both halves of the duplex are equal, it would have been appropriate to use some other percentage if the two units were not equal in value.  The point is that only part of the unit qualifies as the sale of your residence and the other part is the considered the sale of a rental property. 

The part of the sale that is your residence would qualify for the up to $250,000 gain exclusion since you have lived in and owned that part for more than two years. Hence, you won’t have to recognize any capital gains on that part of the sale, as the $250,000 exclusion exceeds any gain.

Assuming the rental part was half of the home, the cost associated with that side would have been $62,500. If you claimed $40,000 in depreciation, your adjusted basis is $22,500. If the property sells for $250,000 net of costs, your selling price for the duplex side is $125,000 and your gain is $102,500, of which $40,000 is depreciation recapture.  The recapture is taxed at a maximum of 25 percent, which would be $10,000 in tax. The remaining $62,500 in gain is taxed at a maximum of 15 percent, or $9,375 in tax.

When you borrowed the $130,000, you didn’t recognize income. For this reason, when it is paid off it doesn’t change your gain. Had you not already stripped the cash out of the property you would have received an additional $130,000 on the sale, which in your way of thinking is your profit.

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