Taxes on home office deduction
After reading your
article about selling a home in which you have been claiming
a home office deduction, I am a little confused. I thought that
as of 2002, capital gains didn't have to be paid on the office portion
of the home as long as the office was within the house. I thought
that only the unrecaptured Section 1250 depreciation deductions
were subject to capital gains tax.
Maybe part of the problem is that I don't understand depreciation. I have never owned a home before, and have not had to deal with depreciating anything, so I really don't understand the concept and how it affects my taxes. I don't understand the term "tax basis."
I bought a home in 2006, and I would like to take the home office deduction, as I did when I was renting, but I want to be sure it will be worthwhile. I bought the home for $489,000. My office space is now 12 percent of my house. I intend to put on an addition this year (which will change my office space to 8 percent) that will cost me $60,000, but bring the value of the house higher. If I were to sell the house in three years for $650,000, approximately what kind of capital gains am I looking at?
Your confusion is understandable; the tax law is full of complex specific terms. Usually, the depreciation deduction on home office deductions is not worth it. Depreciation is a tax deduction that allows you to write off the cost of your investment in income-producing property.
First off, everyone knows the IRS hates home office deductions. If you a claim a home office deduction, you should claim depreciation on the property. If you claim depreciation, then when you sell the property a portion of your gain is subject to income tax. I'll give you an example, ignoring your addition as it just complicates the math.
Your tax basis in your home is your cost of $489,000. Depreciation is only computed on the improvements, not the land. Suppose your land is worth $99,000 so that your basis for depreciation is $390,000. Your depreciation is computed straight over 39 years or up to $10,000 a year. Since 12 percent of the home is your office, your actual deduction is $1,200; for your theoretical three years, it's $3,600 in total depreciation deductions.
When you sell, you'll have $161,000 in gain ($650,000 selling price less $489,000 cost). Since you wrote off 12 percent of your home, 12 percent of the gain is taxed as capital gains. So you pay 15 percent on $19,320 in gain or $2,898 in capital gains tax. You also pay 25 percent tax on the $3,600 in home office depreciation or $900. Your $3,600 in home office depreciation deductions may have saved you at most $1,800 in combined income and self-employment taxes. But in the end it cost you $3,798 in taxes on the sale of the property. The IRS is ahead almost $2,000 so I don't know why it hates the home office deduction so much.
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