Tax Consequences for Home Business Offices
Your tax questions about home business office depreciation, answered
The law allows an exclusion—an escape from taxes—on profit from the 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. However, if you use a portion of your home as a dedicated home office space, it could complicate your exclusion eligibility. It all depends on how your home office affected your tax returns in recent years.
Residence vs. Business Treatment Under Changing Tax Law
Before 2002, the rules were tougher if you used part of your residence for business purposes and then sold your home. 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 cost basis between the residence and business parts.
The IRS has since scrapped those rules and replaced them with new ones that no longer distinguish between a 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, you can exclude the entire profit, despite using part of the home for business.
Your tax break is subject to a “recapture” restriction, which is 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—then the allowable amount is what you could have claimed.
In other words, you can't accept tax deductions for your home office every year and then also accept residential benefits on that same space when you decide to sell. The IRS "recaptures" those deductions, or depreciation write-offs, that enabled you to reduce your tax liability in the years before you sold your home.
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. Similarly, if you no longer qualify for home office deductions under the 2017 Tax Cuts and Jobs Act, you may still be responsible for recapturing deductions, if any occurred within the past five years.
Relief from Recapture
To qualify for relief from recapture, you have to show by “adequate records or other evidence”—past returns are usually sufficient—“that the depreciation deduction allowed was less than the amount allowable.” Then the amount that “you cannot exclude is the amount allowed.” For example, if you were qualified to claim depreciation on your home office, 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%, instead of the top rate of 15% 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.
The information contained in this article is not tax or legal advice and is not a substitute for such advice. State and federal laws change frequently, and the information in this article may not reflect your own state’s laws or the most recent changes to the law. For current tax or legal advice, please consult with an accountant or an attorney.