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Bankrate's 2010 Tax Guide
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Home office can have hidden tax costs

Claiming a home office deduction has many tax benefits. It lowers your taxable income, which lowers your income tax and your self-employment tax.

But it has some drawbacks.

Despite assurances from the IRS that writing off home office expenses won't automatically prompt a visit from a tax examiner, the perception persists that the deduction is an audit red flag.

The deduction also 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. That takes up more of your time to track expenses and deductions, as well as more of your money if you hire a professional to do the job for you.

Then there's the issue of how a home office can affect your tax bill when you sell.

Although a few years ago the IRS 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 main reason for the potential tax trouble is that the most favorable rates afforded residential sales don't apply when it comes to your home office.

Don't overlook deduction
If you write off expenses related to your home office, be sure to take the depreciation deduction. Why? You'll have to recapture that depreciation (i.e., pay taxes) when you sell -- even if you never took the deduction.
Depreciation rules are tricky
  1. Dealing with the depreciation.
  2. Undermined by unrecaptured gain.
  3. Recapturing Section 1250 costs.
  4. Taking note of the depreciable years.
  5. Is it worth it?
  6. Consequences of claiming the deduction.

Dealing with the depreciation

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, senior tax analyst with RIA/Thomson Tax & Accounting in New York. 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 zero percent.

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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. Lower basis will mean you made more profit, perhaps enough to push you over the $250,000 or $500,000 tax exclusion amount.

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