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Home office can have hidden tax costs

Undermined by unrecaptured gain

And even if you stay within the exclusion limit, you still could face some home office-related tax costs. The issue arises when the IRS "recaptures" the tax on the depreciation of any business use of a sold property.

Essentially, Uncle Sam wants to make sure the Treasury gets back some of the depreciation benefits you claimed over the years. This comes into play if you took a home office deduction in the last 11 years, specifically since May 6, 1997.

This recaptured depreciation is taxed regardless of whether your overall gain is more or less than your allowable home sale exclusion amount. And it's taxed at a rate higher than the typical capital gains rate with which most investors are familiar.

Stein offers an example:
You, a single taxpayer, bought your home in 2000, immediately set up a home office in one room and correctly deducted expenses and depreciation.

Over the years, you claimed $10,000 in depreciation on your tax returns.

This year you sell your home and your profit is $100,000.

Your gain is well under your allowable $250,000 tax-free residential sale exclusion. But of that $100,000, the $10,000 that is allocable to the depreciation claimed on your home office over the years is considered taxable gain.

OK, that seems simple enough. It's not the best tax news, but you can deal with the taxes due on $10,000 because, over the years, your home office deductions and associated depreciation provided you substantial tax savings.

Not so fast.

Recapturing Section 1250 costs

Not only is the $10,000 taxable gain, it's a special kind of taxable gain, says Stein.

Although you report it on Schedule D, the form used to detail all your capital gain transactions, it has its own more-costly tax treatment.

"It's called unrecaptured Section 1250 gain," Stein says. "That is a class of capital gains that is taxable at a maximum 25 percent rate rather than the 10 percent to 15 percent rate that is available if you're selling stock or other assets."

In essence, because you've mixed business and residential use of the property, the depreciation deduction you claimed over the years for that home office is really just a deferral of taxes into the year when you sell the residence. And the 25 percent rate applies regardless of your ordinary income tax bracket.

What if you didn't depreciate your home office? You wrote off the space and proportionate utility and maintenance costs, as well as a portion of your rent or mortgage payment, but didn't bother with the depreciation calculations or claim it on your tax return. Do you still have to recapture the Section 1250 costs?
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