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A home office can cause tax complications if you're
not careful
By Jay
MacDonald • Bankrate.com
 Congratulations.
You made the leap from wage slave to entrepreneur, converted the
basement into your world headquarters and received a crash course
from your accountant on all the tantalizing home-office deductions
to which you are now entitled.
But did you know that when you sell your house, the
capital gain on that portion you depreciated as a home office is
going to be taxed by the Internal Revenue Service as if it were
rental property?
It's true.
In fact, you'll owe for every year that you took a
home-office deduction on your federal income tax. And the larger
your world headquarters, the larger the tax bill is going to be.
Now before you speed-dial your congressman to complain,
let's take a mini crash course on this little-known tax unpleasantry.
After weighing the evidence, you may decide that it's right and
proper after all. You may even decide that it's generous. And if
you don't, there may be a way to wiggle out of it.
Whatever course you ultimately decide to take, here's
what you need to know before you sell your home office.
My home vs. my office
When accountants talk about home-office deductions, they're really
talking about two separate components -- indirect expenses and depreciation.
Indirect expenses are all those operating expenses
that go into maintaining your home (and home office). If you own
your home, these would include real-estate taxes, mortgage interest,
home insurance, utility bills, repairs and maintenance, condominium-association
dues and the like. If you rent, your rent payment may be your major
indirect expense.
Depreciation reduces over time the basis of the value
of your home's physical structure, but not the property upon which
it's built.
Here's how it works: If your home office is 20 percent
of your home's total square footage and you use it exclusively for
business, you are entitled to deduct 20 percent of the indirect
expenses of your home and depreciate that portion of your home's
basis for tax purposes.
Now put those deductions for indirect expenses aside;
they are yours to keep.
"The depreciation is the only thing that comes
into play when you sell your house," explains Tom Haas, tax
manager for Reynolds & Associates CPAs in Naples, Fla.
"Your home is essentially divided up into personal
and business. The portion that you've allocated for business use
of your home becomes a business expense and subject to gain or loss
on the sale."
Figuring your home office's
capital gain
Assuming that you make money on your home, the IRS will tax the
capital gain on the home-office portion only for each year you took
the depreciation. For example, if you lived in the house for 10
years but only took the home-office deduction for five, the taxable
portion would be one-half of the capital gain divided by the percentage
of home-office depreciation.
According to Haas, the IRS taxes home office capital
gains at 20 percent, the same figure it uses for business rental
property.
"It's pretty logical that if you're saying I'm
using this as business property, and I'm taking these deductions
as business expenses, then when I sell it, I sell that portion of
it as business property," says Haas.
It may occur to you that in order to avoid the tax
on your home office when you sell, you might simply deduct your
indirect expenses and not take depreciation.
Unfortunately, it occurred to the IRS, too.
"If you have qualified business use of your home
that entitles you to a depreciation deduction, you are required
to reduce your basis in the home by the amount of depreciation allowed
(deducted) or allowable (could have been deducted)," according
to the IRS
FAQs Web page. "Whether you choose to deduct the depreciation
on your current return(s) will not matter. For tax purposes, you
will still be treated as if you had taken the allowable deduction,
and your basis is reduced."
Looking for a loophole
David Hayes, a partner in Dunton,
Hayes & Associates CPAs of Springfield, Mo., says that while
most home-office assessments don't amount to much when the math's
done, the larger the home office, the more it becomes an issue.
"If you live in the Midwest where property is
cheap and you write off 4 percent of your home to business, the
deduction actually becomes pretty small," he says. "But
if you bought good on Siesta Key and you were writing off 50 percent
of a one-bedroom studio when values soared, it could be a big deal.
It could be a real big deal."
The company's Web site directs home-office owners
to what it calls a well-recognized loophole in the tax code: If
you don't declare depreciation the year of the sale and discontinue
use of the home office six months prior to selling, the home office
is no longer being "regularly and exclusively used" for
business, and hence not taxable.
"You should discontinue taking any deduction
that is directly related to the structure," says Hayes. "To
not do that, you throw yourself into the position of looking like
you just manipulated the situation to avoid paying tax. You can
still take other business deductions, but if you take utilities,
then you're saying you still have a home office."
Coming out ahead with a home
office
Haas doesn't think much of the idea of "moving out" of
your home office the year before the sale.
"Once you've taken that home-office deduction,
it's there. That wouldn't eliminate it; it would just be one year
less," he says. "All the IRS has to do is look in their
computer, and if you've ever claimed a home-office deduction, it
would show up. Technically, there is no way around it."
In fact, he says the capital-gains tax is a small
price to pay back for the far more generous home-office deductions.
"Those home-office expenses are Schedule A deductions;
you can't put those on Schedule C," he says. "You're subtracting
them right from total income, not from adjusted gross income. It
makes a big difference."
"You must realize that the portion of the operating
expenses -- the mortgage interest, the real estate taxes -- are
operating deductions against your income. You're getting the benefit
of that at the ordinary tax rate, and then when you sell the property,
you only get taxed at the capital gains rate and only on the physical
asset part of it. So you've gotten all the benefits of the operating
expenses for all the years you've claimed it as a home office, so
you're way ahead."
"The deductions and the tax savings will really
outweigh the capital gains tax when you sell it. You're going to
be ahead always, I think."
Jay MacDonald is a contributing editor
based in Florida.
-- Posted: Dec. 7, 2001
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