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Selling property with home office deduction

Dear Tax Talk,
My husband and I sold our town house this year. While we owned and used the house for over two years, I also used the home office deduction for a room in the town house. We received a 1099-S for the sale of the house.

While the capital gain is less than the \$500,000 for a married-filing-joint exclusion, how do I handle this on the Schedule D? Is it true that I have to add back in all depreciation into regular income, and if so, on what line of which form will it go? Thanks for your help.
-- Jacqueline

Dear Jacqueline,
The downside to claiming home office deductions is that it makes part of the gain on the sale of your home taxable. In exchange for a few dollars in depreciation deductions, you're creating a tax problem when you sell the home.

Suppose you used 10 percent of your \$390,000 home for business for five years. Ignoring land issues, you would have claimed depreciation over 39 years, since it is commercial property. That \$390,000 divided by 39 years at 10 percent for five years equals \$5,000 in depreciation deductions. Suppose you sold the home for \$690,000 so your gain is \$300,000. You would record \$30,000 in Section 1231 gain on the sale of the home plus \$5,000 in unrecaptured Section 1250 depreciation deductions.

The \$5,000 is taxed at a maximum rate of 25 percent (\$1,250 in tax) and the \$30,000 is taxed at a maximum rate of 15 percent (\$4,500 in tax). So on what would have been a tax-free sale you could end up paying as much as \$5,750 in tax. The \$5,000 in depreciation deductions may have saved you around \$2,500 in tax if you were in the highest tax bracket and you figure in self-employment taxes. While \$3,250 in tax cost is small compared to the hypothetical gain, it's still better in your hands than Uncle Sam's.

You should report the business part of the sale on Form 4797 part 3. Use the percentage you used on Form 8829 to figure the home office deduction, as the percentage of the sales price and cost that should be entered on Form 4797. The \$5,000 in depreciation recapture flows through as capital gains but it is disclosed on line 19 of Schedule D.

To ask a question on Tax Talk, go to the "Ask the Experts" page and select "taxes" as the topic.

 Bankrate.com's corrections policy -- Posted: Feb. 7, 2007
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