First Time Home Buyers: Beware of Home Office Hidden Tax Obligations

Working from home definitely has its advantages. There is no commute, the dress attire is comfortable, and you set your own hours. Wonderful! However, just like everything else in life, it also has its draw backs or consequences. Filing taxes for most is already a real pain and for those who file for a home office it really puts your organizational skills to the test. You must maintain meticulous records to take advantage of your allowable deductions such as; rent or mortgage, property taxes, utilities and depreciation for the portion of your home used exclusively for business. Which brings us to the issue at hand, depreciation. Did you know that the depreciation you deduct can later become taxable upon selling of the home? Lets take a look at how it works.

Normal Sale of Residence
Lets first examine selling a home under normal circumstances. A homeowner selling their home would be allowed to make a profit of up to $250,000 or $500,000 for a married couple filing jointly, tax free! Anything over the allowed amount would be taxed at about 15% or as low as 10%.

Sale of Residence with Home Office
Now lets look at the sale with a home office. A few years back the IRS had a change of heart and decided that it would no longer require you to allocate sale profits between the home and office as long as the home office and the residential part are both within a single dwelling. Sounds great right? You sell your home, with the office inside and walk away with a nice round bag of cash, no questions asked, correct? Not so fast. The IRS has what they call the Unrecapture Section 1250 gain on the amount of depreciation that you deducted or that you could have deducted every year after May 6, 1997. That’s right folks, even if you did not take the deduction, you are still obligated to pay taxes on the allowable depreciation.

Recapture Gain
You see, the IRS allows you to offset your income through the depreciation of an asset, however, when you sell that asset the IRS wants to recoup the taxes on that income up to the amount of the depreciation. Since it was a business office, the business tax rules apply to this portion of the sale. Any gain the taxpayer receives, up to the depreciation amount, must be included as ordinary income to offset the earlier deduction. For example: you bought your home in 1999, set up a home office that year and you claimed depreciation over the years of $9,000 for your home office. You then sell the home in 2009 and made a profit that was under the allowable limit. The $9,000 depreciation you deducted over the years becomes taxable gain. Unfortunately you will be taxed at a rate of up to 25% regardless of your tax bracket.

You may wonder, if it’s worth it to take the deprecation deduction since you are only postponing the taxes you’ll be required to pay. I’m not in a position to give you tax advice, however, I would take the deduction since I would be subject to being taxed on the allowable amount whether I use it or not. I strongly advise you to consult with your Accountant or Tax Professional regarding your options.