If you work at home, the home office deduction can be a great way to turn part of your house into a tax break. But you should be aware that it can also trigger a tax bill when you sell the property.
Here’s some background on how the deduction works, and how it affects home sales:
The deduction is available if you have a space in your home that you use regularly and exclusively for work. If you use a room for work only occasionally, or if you use it regularly for work but your children also do homework there in the evening, you probably don’t quality. You also wouldn’t qualify if you use the room to manage your investments but not to operate a business.
A second requirement is that the office is your principal place of business or a place where you regularly meet clients or customers. The office can be your “principal” place of business even if you do most of your work elsewhere – for instance, if you’re a contractor and you go out on many different jobs, but you keep your records at home.
You don’t have to meet this second requirement if your office is a separate structure from your home, such as a detached garage. Also, there are special rules if you operate a day-care business in your home.
If you qualify, you can deduct a portion of your home expenses as a business expense.
Deductible home expenses include rent, utilities, homeowner’s insurance, condo or homeowner’s association fees, and general repairs and maintenance. If your home is 2,000 square feet, and you use 200 square feet (or 10%) as your office, then you can deduct 10% of these costs.
You can also deduct a portion of your mortgage interest and property taxes, although if you do, you can’t also deduct that same portion on your personal income taxes.
If you own your home, you can take a deduction for depreciation – the general decline in value due to ordinary wear and tear for the portion of the home that contains the office.
Finally, you can deduct 100% of costs pertaining specifically to the office itself, such as repainting the room or having a dedicated phone line.
If that’s way too complicated, the IRS also offers a much simpler option. You can simply deduct $5 per square foot. So if your office measures 150 square feet, you could deduct $750.
However, either way, you can’t take a deduction that’s larger than your overall income from your business.
For years, many people have worried that a home office deduction was a “red flag” that would trigger an IRS audit. The IRS has repeatedly said that this isn’t true.
However, something many people don’t realize is that if you’ve been taking a home office deduction and then sell the property, this may affect your taxes on the sale.
In general, a single taxpayer who sells a home that has appreciated in value doesn’t have to pay capital gains tax on the first $250,000 of the gain – and for married couples, the figure is $500,000. That’s true as long as the home was used as the owner’s principal residence for at least two of the past five years.
However, if you’ve been claiming a home office deduction for a separate structure – such as a detached garage – then you must allocate your profit from the sale between the residence and the business property. For example, if you made a $100,000 profit on the sale of your home, but you were claiming a home office deduction for a detached garage that amounted to 20% of the home’s square footage, then you’ll have to pay capital gains tax on 20% of your $100,000 profit.
This rule doesn’t apply if you were claiming a deduction for a room in your house, as opposed to a separate structure. However, if you took depreciation deductions over the years, the total amount of these deductions counts against you in determining if you made a profit of $250,000 (or $500,000 for a married couple). And even if it doesn’t affect that result, you may still have to pay a special capital gains tax on the amount of the deductions. This tax is 25% (unless your income tax bracket is under 25%).
That means that if you took a total of $3,000 in depreciation deductions over the years, you’ll likely owe a tax of $750 when you sell.
What’s more, even if you didn’t actually claim deductions for depreciation, the IRS could still theoretically “impute” the deductions to you, and then charge you a 25% tax on them.