Claiming a home-office deduction lowers your taxable income, which lowers your income tax and your self-employment tax. But it has some drawbacks.
The deduction adds to your tax-filing work and, potentially, to your compliance costs. You need to keep more records and fill out extra forms to claim it.
More significant: A home office can affect your tax bill when you sell.
Although a few years ago the Internal Revenue Service rewrote its regulations so you no longer have to specifically allocate sale profits to the “home” and “office” part of your residence, your in-home workplace still could add to your post-sale tax costs.
The complication comes from that tricky tax factor known as depreciation. This is the tax break allowed for the wear and tear over time on the portion of your home used for business.
“In the simplest situation, where we’re talking about an office within the actual house, the home-office depreciation that was taken on prior returns must be accounted for when you sell,” says Kathy Tollaksen, a CPA with Sikich in Aurora, Ill.
“In an ordinary home sale, you get a chunk of money that’s completely tax-free,” says Frederick M. Stein, a senior tax analyst with RIA/Thomson Tax & Accounting. Single homeowners who sell don’t have to pay taxes on up to $250,000 in profit; the exclusion amount is double for married taxpayers who file joint returns.
Make a profit greater than your applicable limit, and it will be taxed at the most favorable capital-gains rates. Currently, that’s typically 15 percent, but could possibly be as low as 10 percent.
But those rules, says Stein, don’t apply to business property and a home office is considered business property.
If you depreciate the office portion of your home, the amount of that write-off will reduce your property’s basis. A lower basis will mean you made more profit, perhaps enough to push you over the $250,000 or $500,000 tax exclusion amount.
Even if you stay within the exclusion limit, you still could face some home-office-related tax costs. The issue arises when the IRS “recaptures” the tax on the depreciation of any business use of a sold property.
Essentially, Uncle Sam wants to make sure the Treasury gets back some of the depreciation benefits you claimed over the years. This comes into play if you took a home-office deduction in the last 10 years, specifically since May 6, 1997.
This recaptured depreciation is taxed regardless of whether your overall gain is more or less than your allowable home-sale-exclusion amount.
Stein offers an example:
You bought your home in 2000, immediately set up a home office in one room and correctly deducted expenses and depreciation.
Over the years, you claimed $10,000 in depreciation on your tax returns.
This year you sell your home and your profit is $100,000.
Your gain is well under your allowable $250,000 tax-free residential sale exclusion. But of that $100,000, the $10,000 that is allocable to the depreciation claimed on your home office over the years is considered taxable gain.
Not only is the $10,000 taxable gain, it’s a special kind of taxable gain, says Stein.
Although you report it on Schedule D, the form used to detail all your capital-gain transactions, it has its own more-costly tax treatment.
“It’s called ‘unrecaptured Section 1250 gain,’ “ Stein says. It’s taxable at a maximum 25 percent rate instead of the more familiar 10 percent to 15 percent rate that applies when you sell stock.
In essence, because you’ve mixed business and residential uses of the property, the depreciation deduction you claimed over the years for that home office is really just a deferral of taxes into the year when you sell the residence. And the 25 percent rate applies regardless of your ordinary income-tax bracket.
What if you didn’t depreciate your home office? You wrote off the space and proportionate utility and maintenance costs, plus a portion of your rent or mortgage payment, but didn’t bother with the depreciation calculations or claim it on your tax return. Do you still have to recapture the Section 1250 costs?
“Unfortunately for homeowners, that is true,” says Stein. The unrecaptured-Section-1250 rule applies to depreciation that is “either allowed or allowable,” according to IRS language. “Basically, you get stuck with it if you’re entitled to take it, regardless of whether you’ve actually taken it.”
So if you’re going to deduct your home office, be sure to take the depreciation deduction, too.
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