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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.
- Dealing with the depreciation.
- Undermined by unrecaptured gain.
- Recapturing Section 1250 costs.
- Taking note of the depreciable years.
- Is it worth it?
- 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.
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.
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.
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?
“Unfortunately for homeowners, that is true,” says Stein. “This unrecaptured Section 1250 rule, according to IRS language, ‘applies with respect to depreciation that is either allowed or allowable.’ Basically, you get stuck with it if you’re entitled to take it, regardless of whether you’ve actually taken it.”
“The way the rule reads, and this also is for rental real estate, that you are imputed depreciation deductions even if you don’t take them,” she says. “You have to depreciate what you are claiming as business use.”
Because simply deciding against claiming the depreciation amount doesn’t absolve you of owing taxes on it when you sell, you might as well go ahead and get the benefit of it while you’re using your home office.
The depreciable life of business space
Assuming you write off the space and proportionate utility, maintenance and mortgage payments and depreciate your home office space, Tollaksen says you also must be careful in computing the correct amount.
“The depreciation life of your home office is 39 years, since it’s business,” says the Illinois CPA. The IRS has determined the costs associated with business real property must be spread out, i.e., depreciated, over that time period. But often, home office taxpayers misread the rules.
“Many people use the 27.5-year residential property schedule since the office is in their home,” says Tollaksen. “But in the IRS’s eyes, it’s a business regardless of its physical location, so business tax rules apply.”
Remember also, says Tollaksen, that you can’t use depreciation (that you report on IRS Form 4562) to create or increase a loss for business. “You then would have to carry forward that unused depreciation deduction into future business tax years,” she says. “And that’s where adequate records are so important.”
For example, if you experienced a $2,000 loss because your home-based business had a bad year, you could claim the $2,000 loss on your Schedule C. But if your company made just $1,000 and you claimed home office depreciation of $2,000, you can only use half of that depreciation to get your Schedule C income to zero; you can’t use it create a loss. In that case, you would carry the depreciation-created loss forward to the next or future years and use it to offset up to $1,000 of income when you have a better year.
Is it worth it?
There was a period of time, says Tollaksen, “where you positively stayed away from” the home office deduction.
But most tax experts agree that taxpayers should take every tax break to which they are legitimately entitled. The key is to make sure that the maneuvers actually reduce your tax bill. And in some cases, you need to consider not just your current year tax bill, but future ones.
Businesses, says Tollaksen, typically are looking for bottom-line figures that make their financial statements look great and their tax filings look terrible “even if they have to pay in future.”
So, as with most tax situations, you need to run the numbers a couple of ways. The tax savings that a home office deduction produces over the years might indeed outweigh any future tax that the IRS will recapture when you sell. But before you claim it on your next return, make sure you have an idea of the deduction’s potential tax costs down the road. Below is a simple example of what you might have to ultimately pay for your home office.
Last year, you sold your home and made a profit of $200,000. Because it was your primary residence for the IRS-required time (at least two of the five years before it sold), you’re eligible for the home-sale exclusion of up to $250,000.
Since the IRS changed the rules in 2002, the business use of your spare room is not a tax problem. As long as the office is within the house, rather than in a separate structure such as a guest house on the property, you no longer have to allocate the sale profits between residence and business as was the case before. All the home-sale gains are considered excludable from taxes.
The depreciation component, however, will cost you. You’ll owe taxes at the 25 percent rate on that $10,000 you wrote off. So instead of no taxes due upon the sale of your home, you will owe Uncle Sam $2,500.
Also remember that if you decide not to claim a home office deduction, you can still claim other deductions for your small business.
“You’d still be entitled to deduct a separate business phone line and other equipment, desk and furniture, supplies, etc.,” says Tollaksen. “You don’t negate those other business expenses. What you’re saying to the IRS is: I really don’t have a home office.
To convince the IRS that, according to the tax rules, your workspace is not a true home office, you also could, for example, use the room to maintain your personal financial records or have a TV in there where the kids are allowed to watch DVDs.
“I don’t discourage taxpayers from taking it (the home office deduction), but I definitely explain the rules if they’re going to take it,” Tollaksen says. “Then we look at if it is really going to be beneficial. You don’t want to be surprised when you sell.”