home office deduction & house sale

Question

Hi,

I've been getting an IRS home office deduction since the early 2000s, when I started my business.

I am now contemplating selling my house, which I've lived in during this entire time of receiving home office deductions.

QUESTIONS

I thought someone told me that these home office deductions will affect the tax basis for calculating the taxable gain, when I sell the house, which has appreciated substantially. Is that true?
Should I continue to take the home office deduction in the three remaining years I plan to live in the house, or is there now some tax advantage to NOT taking the home office deduction at the end of my time in the house? In other words, is it possible to have lower OVERALL taxes over a three year period, including federal taxes on the gain I make (assuming I sell the house three years from now,) by NOT taking the home office deduction during the remaining three years I plan to live here?

In order for this to make sense, there would need to be some greater advantage in reduced taxes on the gain on the house sale, from not taking the home office deduction in those three years, than the benefit from three years of the home office deduction.

Thanks in advance

Opus 17 · Answer

When you sell, you have to recapture (pay tax on) the depreciation you took or could have taken while the home was in use for a business. That gets taxed before you apply the personal capital gains exclusion. Let me talk about that first, then give you some things to think about.

Suppose the purchase price was $100,000 and you sell for $400,000. You use 10% of the home for business, and business property depreciates over 40 years (or 27.5 for rental, or maybe business is 37.5 or 39, I forget and don't care enough to look it up. It's close enough for our purposes.). Your home office deduction should have included about $250 per year for depreciation. So your total depreciation that you took or could have taken is now about $5000.

That makes your adjusted cost basis = $100,000 (cost minus depreciation)
Selling price of $400,000 makes your gain $305,000.
The first $5000 of gain is taxed as ordinary income (depreciation recapture) with a maximum of 25%.
The next $300,000 of gain is eligible for the capital gains exclusion, if this has been your main home for at least 2 years, you can exclude $250,000 of capital gains.
The last $50,000 of gain is taxed as long term capital gains, 15% for most people and 20% for high income.

Remember you can add other permanent improvements to your cost basis.

You must recapture the depreciation you took or could have taken, even if you didn't.

However, if you used the simplified safe harbor home office deduction ($5 per square foot, maximum of $1500) in any year, then you don't have to keep track of or recapture depreciation for those years.

Going forward, you have already used the home office deduction for 20 years, so claiming or not claiming it now will only affect the last couple of years. If you use the simplified safe harbor method going forward, then you only have to recapture the depreciation you already claimed and you won't increase your recapture any further.

But the depreciation is unlikely to be a huge factor, unless you use a major fraction of your home in the business. And if you give up the home office deduction entirely, you lose the ability to deduct the business-related portion of other home expenses like utilities, insurance and repairs.

Lastly be aware of the effect of inflation on the future value of money. In my example you took a tax deduction of $250 per year over 20 years, which would have saved you around $50 per year or $1000 in total. Now you have to recapture that depreciation and pay that $1000 back in the form of tax on the recaptured depreciation. Due to inflation, $1000 today is worth a lot less than it was 20 or 10 years ago. Taking depreciation is a way of saving money now and paying it back later with no interest and at a discount.