Tax Consequences for Home Business Offices
Your tax questions about home business office depreciation answered
Within the next few years, I plan to sell my home. I use one of its rooms solely as a home office for my business. I have been claiming home-office deductions for a proportional share of depreciation and other expenses associated with the room’s business use, just as I have been writing off all the equipment and furniture stuffed into the office. How do the tax rules work when I sell my home?
Prior to 2002, the rules were tougher if you used part of your residence for business purposes and then sold your home. Yes, the law allows an exclusion -- an escape from taxes -- of profit from sale of a principal residence. The exclusion amount is as much as $250,000 for single persons and married couples who file separate returns, and $500,000 for married couples who file joint returns. But those rules authorized an exclusion only for the portion of the profit attributable to the residence part, prohibiting any exclusion for profit on the office part.
Residence vs Business Treatment
In effect, the IRS treated this kind of sale as if you had sold two pieces of property: one a residence and the other business real estate. Consequently, you had to make separate calculations for the residence and business profits, dividing the selling price, selling expenses and basis between the residence and business parts.
The IRS scrapped the old rules and replaced them with new ones that do away with an allocation between residence and business. The sale is a single transaction as long as the home office and the residential part are both within a single dwelling -- a “dwelling unit,” as agency regulations put it. Accordingly, someone like you can exclude the entire profit, despite using part of the home for business.
This break is subject to a “recapture” restriction designed to prevent a double benefit. You forfeit any exclusion for the part of the profit equal to any depreciation deductions allowed or allowable on the home office after May 1997. Instead, you pay taxes on that part. Allowed or allowable means what you claimed previously or, if you claimed less than you could have claimed, the amount that you could have claimed. In this regard, the new rules do not differ from what the old rules obliged you to do.
What the IRS accomplishes is to recapture depreciation write-offs that enabled you to lower taxes in pre-sale years. The agency still applies the recapture rules even if you cease to use that room for business reasons and the entire home is a principal residence for at least two years out of the five-year period that ends on the sale date.
Relief from Recapture
To qualify for relief from recapture, you have to show by “adequate records or other evidence” -- usually, past returns should be sufficient -- “that the depreciation deduction allowed was less than the amount allowable.” Then the amount that “you cannot exclude is the amount allowed.”
To illustrate, assume that your home office qualified you to claim depreciation, but you can show that you never claimed any.
Then there is no reduction of the exclusion amount and no recapture.
Tax Liability Due on Recaptured Depreciation
Recaptured depreciation is taxed at a maximum rate of 25 percent instead of the top rate of 15 percent for long-term capital gains, plus applicable state income taxes. Report this recaptured amount on Schedule D (Capital Gains and Losses), not Form 4797 (Sale of Business Property). On the plus side, you suffer no recapture of other expenses, such as real estate taxes and mortgage interest.
As with any tax-related issues, please consult with your own tax preparer.
Julian Block is an attorney, syndicated columnist and former IRS special agent (criminal investigator). This article was excerpted with permission from the pamphlet: "The Home Seller's Guide to Tax Savings: Simple Ways For Any Seller to Lower Taxes To The Legal Minimum," which can be ordered by sending $19.95 for a postpaid copy to J. Block, 3 Washington Sq., #1-G, Larchmont, NY 10538.
As of this writing, Elizabeth Weintraub, Cal BRE #00697006 is a broker-associate at Lyon Real Estate in Sacramento, CA.