Home Office Deduction: A Guide To Selling a Residence With A Home Office and Claiming The Deduction
Consider these scenarios:
- Alan is a psychiatrist and has converted a parlor in his home into an office for meeting patients.
- Larry fixes small engines in a shed he built in the backyard of his home.
Alan and Larry started their respective businesses in 2013, and both have made a profit in some years, and had losses in other years. They’ve both taken home office deductions every year since they started in business.
In 2017, Alan and Larry sell their respective homes. When they each file their 2017 tax returns, the IRS could take notice of the home sales and the home office deductions they’ve taken for years, and look more closely.
What Will the IRS Be Looking For?
Because of special rules that apply to home office sales, the IRS will be interested in:
- Where the home office is located, according to IRS rules
- How Alan and Larry claimed their home office expenses over the years
If you have a home office – or if you’re thinking about claiming one – read on for more about why the IRS looks at the home office deduction — and these facts — on your tax return.
*Hint: They significantly affect how much you’ll pay in taxes on a home sale.
Why the Location of the Home Office Matters
The IRS uses several factors to determine whether your home office is officially part of your personal residence. A tax and accounting professional can help you answer this question, because it will affect your tax return.
- If your home office is part of your personal residence, you’ll pay less (or possibly nothing) on the profits you make from your home sale. The profit you make from the home sale will be excluded from taxes (up to $250,000 for a single filer and $500,000 for married taxpayers filing jointly).
- If the home office is separate from your personal residence, you’ll have some more legwork to do. In this case, you’d have to divide your profits between the personal sale and the home office sale. That’s called “allocating gains.” It means that you’ll owe taxes on the part of the sale that’s attributed to your home office, but you won’t owe taxes (up to the limit) on the profit attributed to your personal residence.
The bottom line: Your home office location is important because it affects how much you’ll owe in taxes. A Tax Advisor can help you navigate allocation and exclusion of gains when you sell a residence with a home office.
Why the Way You’ve Taken the Home Office Deduction Matters
Each year, you can choose how you want to claim home office expenses. You can deduct actual expenses for the home office, or use the safe harbor method.
The choice is important, especially when it comes to the yearly depreciation deduction. Depreciation allows for your property’s decrease in value due to normal wear and tear. If you claim home office expenses using the actual expense method, you deduct depreciation if you have a profit. Under the safe harbor method, you don’t.
The method you use also affects your tax situation when you sell the home:
- If you used the actual expense method to claim home office expenses, you’ll owe taxes on all the depreciation you’ve deducted or could have deducted if you had a profit. This is called “recapture of depreciation,” and you can’t exclude it from taxes.
- If you used the safe harbor method to claim home office expenses, you don’t deduct depreciation. So when you sell, you won’t owe taxes on any depreciation.
- Things get more complicated if you’ve switched methods from year to year. In that case, you’ll have to recapture depreciation for any years when you claimed actual expenses, even if you’re using the safe harbor method at sale. Switching between the safe harbor and actual expense methods requires special calculations of depreciation, so it’s a good idea to consult a tax and accounting advisor for help.
What about Alan and Larry?
Getting back to Alan and Larry, do they get a full-gain exclusion? Do they need to recapture depreciation?
As for Alan, because his home office is part of his personal residence, he won’t owe tax on the profits. He won’t need to allocate gains between his personal residence and his home office.
As for Larry, because his home office is separate from his house, he’ll need to allocate gains to the home office, and those will be taxed at the capital gains rate.
Alan and Larry will both need to recapture any depreciation they claimed or could have claimed for any years they used the actual expense method to claim home office expenses.
What About You?
Alan’s and Larry’s situations show why it’s important to do your homework and get good advice before claiming a home office deduction. The choices you make now can greatly affect your tax situation down the road.
A Tax Advisor can help you determine which method may be best for you to claim home office expenses. And when you sell your residence, a professional can help you determine whether you should exclude the gain and/or recapture depreciation.
Do these scenarios hit close to home? Let one of our Tax Advisors assist you. Find an office near you today.