Taxpayers who sell their home don’t need to pay taxes on the sale — “in general.” “In general” is famous last words of the tax code.
What if you’ve claimed a home-office deduction relating to your house? In that situation, it’s likely that some of your sale IS taxable.
Let’s discuss.
Review
Let’s use an example of a home-office deduction. Let’s say the basis of the home is $200,000. Home offices are depreciated over 39 years, because as ridiculous as that is, it’s what the IRS says commercial buildings are depreciated over. So that equals $5,128 of depreciation per year. Let’s say the taxpayer used the house as an office for 5 years. That’s $25,640 of depreciation.*
(*-Note: true depreciation would have a fractional amount in year 1 and again in year 5; for simplicity’s sake in this example, we’re not going down that road.)
Let’s say the taxpayer then sells their home for $250,000.
Section 121 Exclusion
Tax law says a homeowner who has both owned and lived in a home for at least two out of the five years leading up to the sale date can exclude up to $250,000 of gain from the sale (if single) or $500,000 if married.
In our example, the taxpayer bought the home for $200,000 and sold it for $250,000 — a gain of $50,000. As long as they meet the two-out-of-five rule, they’re not taxed on the gain, right? Right, but NOT if depreciation is involved.
Depreciation and the 121 Exclusion
The depreciation of $25,640 reduces the taxpayer’s basis in the home to $174, 360. The true gain on the sale, then, is $75,640. Of that gain, $25,640 is attributed to depreciation. Gain from depreciation is not excludable.
So this taxpayer can exclude $50,000 of the gain from taxation but will have $25,640 of gain to report.
This gain is considered Section 1250 gain and is taxed at the taxpayer’s ordinary tax rate up to a maximum of 25%.
This is a hit a lot of folks aren’t prepared for, and is one of the planning thoughts when it comes to deducting a home office. It might be better to deduct the simplified $5 per square foot instead of taking actual expenses. The simplified method is simply $5 per square foot with no depreciation component.
What About Not Claiming Depreciation?
I often hear people say “well I just won’t claim depreciation, and that solves the problem.” One time an Enrolled Agent even said that to me. “Oh, I just don’t claim depreciation on client returns, so I don’t have to mess with the recapture then.” Argh.
When you sell the home, you must account for “depreciation allowed or allowable.” This means, you’re supposed to account for the depreciation even if you never claimed it, because you COULD have claimed it. Maybe not fair, but that’s how it is. This means, if you’re taking actual expenses, you might as well take depreciation and get the benefit in the here and now, even if it gets recaptured when you sell the home.
Jason,
Great blog article, but there’s one inherently flawed assumption in recapturing home office depreciation on the sale of a home, and that is: the recapture assumes that the business(es) for which the home office expenses are being taken hasn’t folded, and if it has, that any depreciation taken was at least fairly recent.
Put another way, if a business claiming a home office deduction only lasted a few years, and the business folded 15-20 years prior, very few, if anyone, is going to remember that the business had even existed, and those that do remember are probably not going to take the time and effort to locate decades old tax returns just to look up how much depreciation was taken so they can recapture it on the sale. I doubt that even the IRS would remember years-old depreciation that needed to be recaptured. Out of sight, out of mind…
This is a good point I hadn’t thought of before — yes, I am 100% certain the IRS does NOT maintain a rolling database of “you claimed $400 of depreciation on a home office in 2005.” You are right, no one will ever know.