When you take your home office deduction, what you are essentially doing is dividing up your home into two parts: business and personal, explained Paul Prescott, tax director of Arthur Anderson’s real estate services group, based in Los Angeles. Your home office then becomes business property.
The way you calculate your deductions is fairly straightforward. You may take the percentage of the total square footage of the home that you occupy regularly and exclusively for your office or you may take a fraction based on the number of
“If you’ve been using 400 square feet of your 2,000 square foot house for your home office, you may take one-fifth of the cost of your homeowner’s hazard and liability insurance, for example,” said tax attorney and author Susan Jacksack. If you’re using a whole floor of a three-floor house you may deduct one-third the cost of these items.
You may also depreciate the portion of your home used as a home office over 39 years, much as you would any other type of expensive business equipment. If you paid $300,000 for your home and use 20 percent of it for your home office, the business share of the property is worth $60,000. You may depreciate the home office at the rate of $1,538 a year for 39 years.
When it comes time to sell a home that contains a home office, be prepared for some more complicated computations.
First, the tax basis of your home must reflect the depreciation you’ve taken over the years, accountants say. Your home’s tax basis is generally the amount you paid for the property plus the costs of purchase and sale, plus the costs of any capital improvements you’ve made, such as replacing the roof.
“When you compute the gain or loss on the property, you must subtract the amount of the depreciation you’ve claimed over the years from the tax basis of the property,” said Chicago accountant Phil Ravid. “In other words, if you had a home office and wrote off $350 a year for 10 years, you must subtract the $3,500 you depreciated.”
Even after you’ve subtracted the depreciation, you still must deal with the separate business and personal portions of your home.
“Home sellers must be careful because the 24-month rollover replacement rule (which allows you to postpone paying capital gains tax as long as you buy another home that costs as much or more than the home you’ve sold) doesn’t apply to business property — only to private residences,” said Paul Prescott, tax director of Arthur Anderson’s real estate services group, based in Los Angeles.
Because the IRS considers your home office as business property, if you’ve made a profit on your home and you claim a home office deduction, you may have to pay capital gains tax even if you’re rolling over the profits into a new home, Prescott said.
For example, if the tax basis of your home, including the deduction of depreciation for your home office is $200,000 and you sell it for $125,000, you have a $75,000 loss. If you’ve been using 20 percent of the home as your home office, you may be able to take 20 percent of your loss, or $15,000, against your business income.
However, if you sell the same home for $300,000, you’ll have a $100,000 profit. If you’ve claimed that same 20 percent as your home office, $20,000 of that profit is considered by the IRS to be profit on a business asset and taxable. In other words, if the profit on your home office is considered to be a capital gain and taxed at 28 percent, you would owe $5,600 in capital gains tax.
There are ways to avoid paying capital gains on your home office profit. The IRS has so far left untouched a large loophole that allows homeowners to convert their home offices back to residential use at will.
Accountants say if you do not take your home office deduction in the year of your sale, your property will be considered residential. You may then make full use of the 24-month rollover replacement rule.
However, Jacksack and Prescott think it’s a good idea to wait until you’ve been in your new home for a year to claim the home office deduction again. That way, the IRS can’t come back and accuse of trying to avoid the capital gains tax on business property.
The basic penalties for cheating on the home office deduction start at about 20 percent of the additional tax due; imprisonment is also possible, Prescott said.
Is it worthwhile to take the home office deduction? Not in every case.
“We don’t claim a home office deduction even though we could be eligible,” Jacksack said. “The IRS is more likely to audit you if you claim a home office deduction. In our case it’s a small amount of money and not worth the trouble.”
Experts agree that even if you choose not to use the home office deduction, you can still deduct the direct expenses of your business, including office supplies, postage, a business telephone line with call waiting, office furniture and computers.
“What you’re gaining from the home office deduction is the ability to deduct a portion of your insurance premiums, utilities and repairs, plus the depreciation,” Jacksack said.
“You have to have your tax advisor look at the dollars. But what you may end up saving may be less than the cost of your accountant’s time to calculate it,” she added.