Tax Tips
April 2003
Sale of a Residence with a Home Office
Taxpayers who see clients in an office located in their home, may be entitled the tax breaks available for such usage. However, for those claiming these deductions, there is a potentially expensive tax trap that can hit when the time comes to sell the residence.
Normally, when a taxpayer sells his home at a profit and "moves up" to another one, there is not a tax to pay on the sale because of the $250,000 exclusion of gain tax break on the sale of a principal residence (joint filers get a $500,000 exclusion). However, when there was a home office, or the taxpayer has taken the home office deduction in the past, an extra bit of planning must be done in order to secure the full benefit of the exclusion.
Fortunately, the IRS recently 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 a taxpayer used his residence for both personal and business purposes, he 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 realized on the sale of the home would be entitled to the $250,000/$500,000 exclusion, but any profit realized on the sale of the business part of the 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 the gain subject to tax is the amount of depreciation deducted in the past as a home office expense.
To put the good news in an example: Assume the taxpayer used his library room exclusively as a home office. The library occupies one-twelfth of his home, and he took $10,000 in depreciation for that room over the years. Assume further that he purchased the home for $240K and just sold it for $600K. Before the new IRS rules, one-twelfth of the sale or $50,000 would be attributable to a business portion with a tax basis of $10,000 yielding a $40,000 taxable gain, even though the entire profit would otherwise be covered by the $500,000 exclusion to which the taxpayer and his spouse would be entitled. Now, only $10,000 of his former depreciation deductions would be denied the exclusion and the rest of his 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.
Taxpayers planning to set up a home office in a free-standing garage, guest house or backyard bungalow, however, need to think carefully about the tax implications. In cases in which the home office is not in the same building in which the taxpayer resides, the old rules continue to apply, and a significant portion of the home sale exclusion will be lost.
If you have any questions as to how these rules apply to
your particular situation, please do not hesitate to call
WJH at 512-343-8075.
