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Steve Windhaus Ask the Small Biz Adviser

Small Biz Adviser: Depreciation rules and taxes for home-based businesses

Dear Small Biz Adviser
Can I depreciate my home if I don't have my own small business? If I can, then, if I depreciate part of my home as "business use of the home," where do I depreciate the rest of my home?

Dear Kent:
Your first question can be answered immediately. You cannot depreciate your home on IRS returns if there is no business use of the structure. It is only when you operate a business out of the home or rent part of the home that depreciation can be taken. If you operate a home office as an employee this depreciation expense cannot be deducted.

Typically, when qualified, depreciation on the home is for a period of 39 years. And you depreciate only that portion of the home devoted to the small business or rental activity.

You deduct depreciation only on that percent of the home that is devoted to the business or rental activity. Furthermore, you can depreciate beginning only at the point in the 39-year time span of ownership that the office or rental space has been designated.

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And example of this situation is the following:

  • Original value when you assumed ownership of the home is $390,000.
  • Depreciation is limited to only 39 years.
  • In this example the annual depreciation is equal to $10,000 annually.
  • Your home office or rental area equals 10 percent of the total square footage of the building.
  • Therefore, you can depreciate only 10 percent of the annual depreciation, which equals $1,000. The other $9,000 cannot be depreciated.
  • The depreciation expense is deducted only from the business or rental income.
  • If you started the office or began renting the space in the 16th year since owning the home, your depreciation expense can be deducted only for 24 years.

I operate a home-based business, but did some very serious homework on the issue before filing my first IRS returns. If you eventually sell your home the IRS will expect you to add up the years of depreciation deductions. You see, the IRS is going to charge you a tax rate of 25 percent on that total depreciation deducted. Uncle Sam sees the sale of your house as an opportunity to recapture the taxes you avoided in the past.

Regarding this IRS rule, do recall you are exempt of tax on gains up to $250,000 profit from the sale of your primary residence, and if you lived in the residence for two of the last five years before selling it. That exemption increases to $500,000 for a married couple. But any depreciation for business use of a home claimed after May 6, 1997 cannot be exempted. You'll need to report the gain on the portion of the house that was used for business purposes and pay taxes on that gain. IRS Publication 523 explains in more detail, and gives an example of the tricky math involved to arrive at the gain.

I am not familiar with your personal financial status or the success you apparently have encountered operating the home business, but you'll need to figure out whether the tax at the back end is worth the savings now.

I would like to suggest you read my column of Jan. 4, 2001, on home office deductions. Some are commonly known, while deductions for certain home maintenance, finance and utility expenses can be partially directed to the business. Review IRS Publication 587 for more details on those deductible expenses.

I wish you well.

-- Posted: Jan. 16, 2001

Bankrate.com writers base their answers on our editorial content and advice of financial professionals. We make no claims or representations about the accuracy, timeliness or completeness of such content, advice or the answers provided to you. Our content, advice and answers are intended only to assist you with your financial decisions. However, by its nature such information is broad in scope. Your financial situation is unique, and our content, advice and answers may not be appropriate for your situation. Accordingly, we recommend that you get different opinions and seek the advice of your accountant and other financial advisers before making any final decisions or implementing any financial or investment strategy.

 

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