The U.S. tax code allows for an exclusion—an escape from taxation—for the profit you might realize on the sale of your personal residence. The exclusion amount is $250,000 for single individuals and for married couples who file separate returns, and $500,000 for married couples who file joint returns. But several qualifying rules apply.
It can complicate your exclusion eligibility somewhat if you've been using a portion of your home as a dedicated home office space.
The Home Sale Exclusion
The home sale exclusion lets you to escape taxation on proceeds from the sale of your personal residence. It dodges capital gains tax, not income tax. You must have owned and lived in your home for two of the last five years ending on the date of sale. These two-year periods don't have to have been concurrent. It's not necessary that you lived in and owned the property simultaneously for the same two years.
What Is Depreciation?
U.S. tax law also provides that you can depreciate the portion of your property used for business purposes. You're effectively claiming a tax deduction equal to the cost of the portion your home dedicated to your office. For example, you could depreciate 15% of your home's value if your office takes up 15% of your home's square footage.
This isn't a one-time deduction. The cost is spread out over a period of years representing the asset's useful life.
Residence vs. Business Treatment
The rules were tougher prior to 2002 if you used part of your residence for business purposes then you sold your home. The IRS treated this kind of sale as though you had sold two pieces of property: one a residence and the other business real estate. You had to make separate calculations for the residence and for business profits, dividing the sales price, the selling expenses, and your cost basis between them.
The IRS has since scrapped those rules and replaced them with ones that no longer distinguish between a residence and business. The sale of your property is considered to be a single transaction, provided that your home office and the residential part of the premises are both within a single “dwelling unit.” Your office can't be in a separate building outside.
You can therefore exclude the entire profit, despite using part of the home for business.
Your tax break is subject to a “recapture” rule, which is designed to prevent a double tax benefit on the same transaction. You can't both claim depreciation on your property and the home sale exclusion as well.
You'll forfeit a portion of the exclusion equal to any depreciation deductions you took on your home office after May 1997—even if you didn't claim any depreciation. The IRS says that all "allowed or allowable" depreciation must be factored into the sale.
"Allowed" depreciation means that you previously claimed a tax deduction for the office portion of your home. "Allowable" means you claimed less than you could have claimed or nothing at all. The point is that the depreciation rule was available to you whether you made use of it or not.
You must pay capital gains tax on a portion of your home sale profit equal to that amount of depreciation. You can't accept tax deductions for your home office every year, then also accept residential benefits on that same space when you decide to sell. The IRS "recaptures" these 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 stop using that room for business reasons and the entire home is treated as a principal residence for at least two years out of the five-year period that ends on the sale date.
You might still be responsible for recapturing depreciation if you no longer qualify for home office deductions under 2018's Tax Cuts and Jobs Act (TCJA), although the TCJA only eliminated this tax perk for employees, not the self-employed. The home office deduction is a whole separate tax break.
Tax Liability Due on Recaptured Depreciation
Recaptured depreciation is taxed at a maximum rate of 25%, rather than the common rate of 15% for long-term capital gains. Applicable state taxes might also apply. You should report this recaptured amount on Schedule D (Capital Gains and Losses), not Form 4797 (Sale of Business Property).
NOTE: The information contained in this article is not tax or legal advice, and it's not a substitute for such advice. State and federal tax laws change frequently, and the information in this article might not reflect your own state’s laws or the most recent changes to the law. Please consult with an accountant or an attorney for current tax or legal advice.