What are the Tax Consequences of Deducting a Home Office if You Sell Your Home?
As the tax deadline approaches, it is time to start thinking about some of the tax questions that are still lingering: What will the home office deduction do to your taxes if you sell your home?
I freelance as a staff writer, as well as own my personal blog Frugal Confessions. For the 20-30 hours that I spend each week working on my writing and on blogging (commenting, tweaking the look of my blog, security backups, plugins, widgets, glitches…the task list of keeping a blog running smoothly could go on and on as Madison well knows) I am able to take a home office tax deduction as one of my self employed tax deductions. What a blessing! Not only for the tax deduction, but also because it indicates that I am making money from the pursuit of my passions: writing and frugality.
Home Office Deduction
I figured out that approximately 12% of our home is dedicated to my office, a room that has no other purpose but to help me create. This was done through taking a tape measure of my office, then dividing that square footage by the square footage of our home. This means that 12% of our mortgage interest we have paid, property taxes, utility, etc. can all be deducted from my business income if I use a home office tax deduction.
For the last two tax years I have taken advantage of this home office tax deduction. After all, I am genuinely using a home office for my blogging and writing business, and this is a great tax write-off against the income I have pulled in. However, somewhere along the way over the last two years I browsed an article or two discussing the possible tax implications and consequences of deducting a home office when/if we are ready to sell our home. We are in our dream home with plenty of space for just the two of us, or for a large family if we decide to go this route. But these articles have raised my suspicion of this tax deduction. I claimed it on my 2011 taxes and have even submitted these before diving into the ins and outs of the home office, but thought it was about time that I educate myself and others on the possible tax consequences involved.
From what I’ve researched, by claiming a home office tax deduction, you are re-categorizing part of your home as a business property. As such, you are taking a depreciation of the business asset (part of your home) and getting a tax advantage from this. Here’s a breakdown of this as a potential tax consequence:
Capital Gains Exclusion for the Selling of a Residential Property
Typically, the first $250,000 in profits realized from a primary residence upon sale is not taxed by the IRS (the limit increases to $500,000 if your filing status is married, filing jointly). In order to exclude the $250,000 from being taxed, you must meet an ownership test, a use test, and you cannot have excluded gain from the sale of another home for the last two year period from the date of settlement.
Recapturing Home Depreciation through Taxes
If part of the home was used for business purposes and reported this way on taxes, then the depreciation must be recaptured when figuring out the tax on the sale of the property. This is because when you take depreciation on something, it means the value has lowered over time. And you are allowed to deduct this depreciation on your home if you use it for business purposes. However, if you then sell the home for a profit, it means that the asset actually never depreciated. So the tax savings to you over the years must be recaptured from the profit of the sale.
The tax rates on the recapture are different than the regular tax rates that apply to the rest of your income. The maximum tax rate for this depreciation taken on the home is 25%, though there is a table that will help with figuring out your own tax rate on the recapturing of the depreciated value taken over the years. To figure the tax rate on recapture of depreciation, you can use the worksheets included in the IRS instructions for Schedule D.
By deducting the home office, you reap some tax savings now. But it appears that you will owe taxes on part of your home’s sale price because aside from the last few years that have devalued home properties substantially, homes generally increase in value rather than decrease in value. If you sell your property at a profit, the depreciated portion that was deducted over the years will need to be recaptured, and it will be taxed at a maximum of 25%. Another nice thing I found out by researching this is that you do not “forfeit†any of the other deductions made over the years (such as mortgage interest and property taxes) when you sell your home.
I have decided that it is still worth it for me to claim a home office deduction, and am quite happy to understand the tax consequences of this decision instead of worrying about them.
For more information, check out IRS Publication 523 and IRS Publication 587: Business Use of Your Home.
More Self Employed Tax Topics
Instead of bothering with the depreciation expense and keeping track over the years, only to recover it when you sell, couldn’t you just deduct the mortgage interest, taxes, insurance and utilities portion? Seems a lot simpler to me.
Whether or not you take the deduction for depreciation, if it was allowable then you will need to include it in your calculations.
Also, it will probably almost always make sense to take the home office deduction, when applicable, to offset self-employment income. This is because you have to pay income taxes and self-employment taxes on your self-employment income. Additionally, if you do sell your house at a profit or even a loss, you may receive favorable tax treatment on the business portion. This is just a general response as each situation is different.
i hate taxes. 🙁