Is Taking a Home Office Deduction Always a Good Idea?

Q: Tax Playa, my spouse is active duty military. I work from home. We are new home owners. (2 yrs).  If I deduct my home office this year, what are the drawbacks for doing so?  I have always deducted a home office when renting a home, but never when owning it. Last year I skipped the whole topic because I didn't understand it. This year I don't want to throw away the deduction if it won't potentially hurt us. We are due to transfer in the next one to two years and may have to sell the home. What do you suggest?

A: Taking a home office deduction is usually one of the best things you can do, but there are narrow circumstances in which it doesn't make sense: if you plan on selling the home in a short period, or have a home office separate from the structure...

I spoke in more detail about home office deductions before, so you should read that first before proceeding.

When you claim a home office deduction, you are re-constituting part of your home as a business asset.  If you're renting, this is not a big deal.  Since you never owned the asset to begin with, you never have to worry about sales issues.

It gets a little less clear-cut when you have a home office in a home you own.  Normally, you can exclude up to $250,000 in long-term capital gains ($500,000 if MFJ) from the sale of your primary residence if you owned and lived in it for 24 months prior to sale.  This is only for personal-use property.

However, when you have a home office that is not a part of the structure of the home, you are converting a part of your personal residence into a business asset.  Provided that business asset remains as such right up until sale, you really have two gains: your personal gain (which benefits from the exclusion described above), and your business gain (which does not).

What does this mean in the real world?  Let's say someone purchases a home for $300,000 and then sells it 2 years later for $500,000.  In ordinary circumstances, the $200,000 in gain can be excluded.

But suppose the home has a separate, 10% home office?  In that case, there are two gains:

1. $450,000-$270,000 is the $180,000 personal gain (fully excluded)
2. $50,000-$30,000 is the $20,000 business gain (long-term capital gain)

On the business gain, there are two taxes to pay:

1. $20,000 gain x 15%, or $3000 in federal capital gains tax
2. The depreciation recapture, which is 25% x $1538 in depreciation claimed, or $385.

Therefore, this person has gone from excluding their entire sale to having to pay $3385 in taxes.  Over the years, the depreciation claimed likely equaled the recapture tax, so this could easily be discounted.

From this, we can glean a few lessons about taking the home office deduction:

1. In order to make it worth your while, it should be at least 10% of the square footage of the home.  Anything less than that, and it just isn't worth the hassle.
2. The deduction is best claimed by someone who is self-employed.  That way, the deduction is both pre-income tax (canceled out by the depreciation recapture) and pre-SECA (a bonus 15.3%).
3. If someone isn't self-employed, it's best claimed by someone in a tax bracket higher than 25%.
4. If there are significant home office deductions beyond interest, property tax, and depreciation (utilities, insurance, home owners association and condo dues, etc.), this weighs in favor.
5. Renters should almost always take a home office deduction of any size if eligible.
6. If someone plans on not selling a home for a long time, then they should probably take the deduction.
7. If somone wants to do a like-kind exchange on their home office, that means it is probably a good idea.

It's important to note that a home office that is part of your dwelling (which is the case most of the time) is eligible to be protected by the capital gain exclusion.  Depreciation recapture is always taxable given a gain.

Comments

[Gina]

Excellent blog!

The IRS has ruled that you do not need to allocate the gain on the sale of your home between personal and business property, IF your business property is part of your main home (such as a separate room used as a home office). This, of course, makes the home office deduction much more beneficial that you stated in your article.

Of course, you will still have a gain equal to the amount of depreciation allowed or allowable after May 6, 1997.

I'm fairly certain Publication 523 was updated with this information.

Best wishes,
Gina

[Ryan Ellis]

Clarified. Thanks for that--accuracy is key, and I was rushing a bit yesterday.

What I really wanted to emphasize was two elements (and did so poorly):

1. Selling before ownership and use kick in;

2. Having a home office separate from a structure.

That should clear things up.