Meet Penelope, a fictional, full-time freelancer who offices from her small (but cozy!) home. Since her home office takes up about 25% of her home, she’s been deducting 25% of her maintenance costs as business expenditures for the past five years. But now she’s ready to sell her home. What tax implications can she expect to face? Does the IRS now classify 25% of her profit as business income? Here’s what to expect when selling a home with a home office.
Where is Your Home Office Located?
If Your Home Office is Located Within the Walls of Your Personal Residence…
This is great news for Penelope (and you, if it applies)! 100% of your earnings from selling your home should qualify for the home sale tax exclusion. Additionally, you’re not required to divide your profit between personal and business taxes, but you might still owe taxes based on how you filed your deduction.
If Your Home Office is NOT Located Within the Walls of Your Personal Residence...
If your office is housed in a structure that’s not physically connected to your home (i.e. a shed), for tax purposes, you’re technically selling two properties. You’ll use Form 4797 to report this income and determine what you owe. If you know you’ll be selling your house in the not-so-distant future, it’s wise to move your home office inside your personal residence if possible. If you don’t use the detached structure at all in the year you sell your home, this rule won’t apply.
Regardless of where your home office is located, you’ll still owe a capital gains tax on your depreciation deductions for the office. Tax depreciation is the depreciation expense you claim on a tax return to compensate for the loss in the value of the tangible assets (such as wear and tear) used in income-generating activities. These deductions are taxed at a 25% rate, unless your income tax bracket is lower than 25%.
Say Penelope paid $200,000 for her home (which includes her office), six years ago. Then, she lucks out and sells her home for $300,000, earning a $100,000 profit. If her depreciation deductions for her office total $2,000, she’ll pay a tax of 25% of $2,000, or $500.
In 2013, the IRS created a simplified option to help taxpayers calculate the deduction for the business use of their home. It doesn’t change the criteria for who may claim a home office deduction; it just simplifies its calculation and recordkeeping requirements.
Here’s a snapshot of the simplified option’s highlights:
- Standard deduction of $5 per square foot of home used for business (maximum 300 square feet)
- Allowable home-related itemized deductions claimed in full on Schedule A (For example: Mortgage interest, real estate taxes)
- No home depreciation deduction or later recapture of depreciation for the years the simplified option is used
A helpful side-by-side comparison of the two options is available here.
Contact Us For More Information
Now that we’ve laid a basic foundation for what to expect when selling a home with an office, you may still have questions. If you’d like some counsel as you move through this process, our tax experts here at Core Group are happy to assist. Please set up a discovery call with us at your earliest convenience, and we’ll help you devise a wise plan of action.