If you use part of your home as an office and take deductions for related expenses on your annual tax return, can you claim a valuable federal tax break when you sell? Specifically, can you claim the capital gains exclusion of up to $250,000 for single taxpayers ($500,000 for married couples filing jointly)? In many cases, you can still take advantage of this tax benefit.
As long as your deductible home office space is in the same dwelling unit as your residence, you can use the gain exclusion to shelter profit from the entire property. In other words, you are not required to split the sale into two separate deals for tax purposes (one transaction for the sale of the residential part of your property and another for the sale of the office part).
However, you will be taxed on gain up to the amount of depreciation deductions on the office part of your property that were claimed after May 6, 1997. You will owe a maximum federal rate of 25% on this profit (called unrecaptured Section 1250 gain).
However, paying tax on this portion of your profit is not really so bad, considering that you collected earlier tax savings from the office part of your property.
The tax outcome is less favorable when the office is not in the same dwelling unit as the residence.
For example, say you claimed home office deductions for what was formerly a carriage house, garage, or finished basement with cooking and bathroom facilities and a separate entrance. In these cases, even though the office is on the same property or in the same building, it is considered to be a separate dwelling unit that is not part of the residential portion of your property. In these scenarios, you must pass the ownership and use tests (see right-hand box) for both the office portion of your property and the residential part in order to treat the sale as a single transaction that is eligible for the gain exclusion.
If you fail the tests for the office part (for example, because it was used as a deductible office for the entire five-year period ending on the sale date), you must calculate separate gains for the office and residential portions of your property. Then, you can use the gain exclusion only to shelter profit from the residential part. Any gain on the office part is usually fully taxable. You will generally owe a federal income tax rate of no more than 25% on gain up to the amount of post-May 6, 1997 depreciation and no more than 15% on any remaining profit from selling the office part of your property.
Here are a couple of smart strategies if you are thinking about selling property that has also been used as a home office:
Strategy #1. When the office space is in a separate dwelling unit, and you think you may sell the whole property before too long, consider not taking home office deductions for at least two years before the anticipated sale date. That way, you are allowed to use the gain exclusion to shelter profit from the entire property (subject to the recapture rule).
Strategy #2. Continue claiming home office deductions if your office space is in the same dwelling unit as your residence. Under a strict interpretation of the rules, the IRS says you must recapture allowable post-May 6, 1997 depreciation whether or not you claimed it, so you may as well benefit from the write-offs.
What Can You Deduct?
If you qualify to take home office deductions, you can deduct a portion of expenses including mortgage interest, depreciation, utilities, insurance, and repairs.
- The office must be used regularly and exclusively as your place of business, which means personal activities cannot be conducted there. Here are a few other tips for home office deductions:
- Take photos to prove the room was used for business purposes in case of an IRS audit.
- To figure the percentage of your home used for business, you can use two methods — square footage or the number of rooms.
- If you don’t qualify for the deduction, you might be able to get a write-off for the expenses involved in storing business inventory or product samples in a room in your home.
- Home office deductions can’t exceed your income. But if they are greater, you can carry the loss forward.
- If a home office is required by an employer, it’s a good idea to get a written statement from the company explaining the requirement.
Gain Exclusion Qualification Rules
If you are single, you can potentially sell your principal residence for a gain of up to $250,000 without owing anything to the U.S. Treasury. If you are married and file jointly, you can potentially pocket up to $500,000 without paying federal tax. To qualify, you generally must pass both of these tests:
- You must have owned the property for at least two years during the five-year period ending on the sale date (referred to as the ownership test).
- You must have used the property as a principal residence for at least two years during the same five-year period (referred to as the use test).
To be eligible for the $500,000 joint-filer exclusion, at least one spouse must pass the ownership test, and both spouses must pass the use test.
If you excluded a gain from an earlier principal residence sale under these rules, you generally must wait at least two years before taking advantage again. For joint filers, the exclusion is only available when both spouses have not claimed an exclusion for an earlier sale within two years of the sale date.
Gain beyond what you can exclude under these rules is generally treated as a long-term capital gain taxed at a maximum federal rate of no more than 15%. However, gain caused by depreciation deductions on the part of your home used as a deductible office may be taxed at up to 25%.
Contact us if you are contemplating the sale of property with a home office. Advance planning may be necessary to maximize your tax savings.