Home Office Depreciation Recapture: Tax Implications for Creative Entrepreneurs

Virtually every entrepreneur in a creative industry has used their home for business at some point. Many of them don't realize the valuable tax savings available with the home office deduction. But beware! There are traps for taxpayers as well as opportunities. Read on to learn more.

Overview of Tax Implications

Basically if you have a qualified home office it is just the same as any other office space. You can deduct business expenses if they are reasonable and necessary expenses. This includes:

Rent, or interest and depreciation, if you own your home

• Insurance

• Repairs & Maintenance

• Utilities

• Home Association Dues

• Security

• Real Estate Taxes

They key is to make sure that the home office is qualified, otherwise you can't deduct anything.

Definition of Home and Business Use

In order to be a qualified residence, there are two items the Internal Revenue Service requires. The first is that it the space is used regularly, and exclusively for business. The second is that it be the principal place of your business. Incidental or occasional use doesn't qualify.

This doesn't mean that you can't conduct business elsewhere, or even have another office. The IRS will look at the facts and circumstances of your business to make the final decision, but is only if they ask under examination.

Calculating the Percentage Used for Business Purposes

Additionally, any structure will do, even a mobile home, if that is where you live. You can even use separate free standing structures like a detached studio. When computing the deduction for your home office portion, it is based upon the percentage of the business portion square footage compared to the total. So if you have a 200 square foot office, and your total home is 1,000 square feet, you can deduct 20% of the applicable expenses. 

This doesn't change the nature of your primary residence to business property, so all of the rules and exceptions for primary residences still apply.  This includes the First-Time Homebuyer Tax Credit and various energy credits.

The IRS has a 34 page publication (number 587) with all of the detail. It even has a flow chart, if you want to make the determination yourself. Personally, I recommend consulting a qualified tax professional.

Beginning in 2014, the federal government offers its simplified option to compute the home office deduction. This simplified option can only be used for a maximum space of 300 square feet. You are allowed $5 per square foot, but you are allowed to deduct 100% of your home-related itemized deductions such as the mortgage interest deduction on your personal residence in full. Since many people don't itemize, and you won't be allowed those expenses against potential self-employment income, I don't recommend the simplified option.

 

The Sales Trap

When you have used your home, not a rental property, for business and have taken depreciation, meaning you didn't use the simplified option, and you sell your home, there are additional tax consequences. Taxpayers must consider issues around basis and depreciation recapture when preparing their returns. You likely will have a taxable gain.

This shouldn't be confused with the exclusion of gain afforded taxpayers on the sale of their principal residence. That exclusion is currently $250,000 for a single taxpayer that holds the home for the required time period. Taxpayers can still exclude this gain, but still have a tax liability from the depreciation recapture.

Determining the Sale Price

Seems easy enough right? Don't forget to reduce your sales price by the applicable closing costs. These include title insurance, pro-rata property taxes, inspections and repairs.  Personal property should be also excluded from the selling price.

These are all tax deductions when calculating your depreciation recapture. You want to calculate your taxes using the net amount.

Calculating the Home's Cost Basis

Generally, the principal residence cost basis is simply the purchase price you paid for it, less the allowable depreciation.  This is key, because the computation is based on allowable depreciation whether you  took as a deduction or not. However, you can add any improvements you made to your primary residence as well. We use the home's sale price less the its cost basis to determine the depreciation recapture.

Example

Calculating Depreciation Recapture on Sale of Property

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. 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 and you used the simplified method…

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 capital gains and losses and determine what you owe.  See Depreciation Deduction below.

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.

If Your Home Office is Located Within the Walls of Your Personal Residence and you used the regular method…

Same as above as if your office was in a separate structure.  

Depreciation Deduction

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 generally taxed at a 25% rate, unless your income is below the threshold.  Then you may be eligible for a lower rate.

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 have a taxable gain and pay a tax of 25% of $2,000, or $500.

A helpful side-by-side comparison of the two options is available here.

Conclusion

In conclusion, navigating the tax implications of selling a home that was used partly for business can be complex, but with the right knowledge and guidance, it can also be a rewarding endeavor. By understanding the basis and exclusion rules, consulting with a tax advisor, and keeping detailed records, you can maximize your tax benefits and minimize any potential pitfalls. Remember, knowledge is power when it comes to taxes, so arm yourself with the information you need to make informed decisions. Happy selling!

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