Sale of a Residence with a Home Office
By Peter Jason Riley
If you write off an office located in your home, you're certainly aware of the tax breaks available for such usage. Although you have been claiming home office deductions for a number of years, you may not know about a potentially expensive tax trap that can hit you when the time comes to sell your home.
If you're planning to sell your home at a profit and "move up" to another one, you may be assuming that there won't be a tax to pay on the sale. Usually, that is a pretty good assumption because of the $250,000 exclusion of gain tax break on the sale of a principal residence (joint filers get a $500,000 exclusion; a surviving spouse can continue to use the $500,000 exclusion if the jointly owned residence is sold within two years after the death of the individual's spouse). However, when you have a home office, or have taken the home office deduction in the past, you may have an extra bit of planning to do in order to secure the full benefit of the exclusion.
Fortunately, the IRS eventually fixed a problem with the home sale exclusion that threatened to wreak havoc on those taxpayers who have a home office and take depreciation deductions for it. Prior to issuing corrective regulations in December 2002, the IRS operated under the rule that, if you used your residence for both personal and business purposes, you would be treated as having sold two separate properties for purposes of using the home sale gain exclusion: a personal residence and a business building. The profit you realize on the sale of your home would be entitled to the $250,000/$500,000 exclusion, but any profit you realize on the sale of the business part of your property would be taxed.
Final IRS rules no longer require most taxpayers who claim the home office deduction to allocate gain between business and residential portions of their home if the business use occurred within the same dwelling unit as the residential use. Instead, a portion of your gain subject to tax is the amount of depreciation you deducted in the past as a home office expense.
To put the good news in an example: Assume you used your library room exclusively as a home office. The library occupies one-twelfth of your home and took $10,000 in depreciation for that room over the years. Assume further that you purchased your home for $240K and just sold it for $600K. Before the new IRS rules, one-twelfth of the sale or $30,000 would be attributable to a business portion with a tax basis of $10,000 yielding a $20,000 taxable gain, even though your entire profit would otherwise be covered by the $500,000 exclusion to which you and your spouse would be entitled. Now, only $10,000 of your former depreciation deductions would be denied the exclusion and the rest of your profit, $360,000, would all be tax free.
This more liberal application of the exclusion rules is made retroactively applicable to all open years, making refunds available in certain instances.
If you have plans to move or set up your home office to a free-standing garage, guest house or backyard bungalow, however, you need to think carefully about the tax implications. In cases in which your home office is not in the same building in which you reside, the old rules continue to apply and you may find you will lose out on a significant portion of your home sale exclusion.
If you need any help in arranging things to save as much tax as possible on the sale of your home and office, we will be happy to assist you. Please do not hesitate to call any time for a confidential discussion.