Home Office Deduction
by Peter C. Brown

If you're taking a tax deduction on a home office, you may be in for a nasty surprise when you sell your house. Here's why.

There are two kinds of tax benefits available to people who qualify for the home office deduction. One is a deduction for operating expenses and maintenance costs. The other is depreciation of your capital investment. You can take either benefit or both. In each case, you must figure the tax benefit on a pro-rata basis. For example, if your office constitutes ten percent of your home, you can depreciate ten percent of your capital investment in the house.

Here's the catch: When you depreciate your home office, you lower your cost basis for the house. When you sell your house, the depreciation will be recaptured, and you will owe taxes on it. What's worse, the recapture amount will be taxed as income, not as a capital gain.

The rationale goes something like this: Since the portion of the house that you depreciated was associated with a business purpose, the recapture is not eligible for the rules applying to capital gains on residential property, meaning you cannot roll the gain forward into the basis of your new house. The tax must be paid in the year of the sale.

There is another possibility, too. If you have been taking the deduction for depreciation but subsequently stop using your home as an office and discontinue depreciating it for some period of time before you sell it, there is evidence that the IRS will levy capital gains tax on the difference between the sale price and the new cost basis, but will not treat it as a recapture subject to income tax. Under the new tax law, capital gains on real property are subject to a 25% tax.

There is good news about the home office deduction. Currently, to qualify for the deduction, your home office must be the only office for your business, and the place where the principal money-making activity of your business is performed. Beginning in 1999, a home office will be eligible so long as it is the sole office for your business and is used regularly for essential administrative or management activities. The money-making activity may be performed elsewhere.