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Capital Gain Impacts Home-Business Deduction

If you have turned the family den into a home office — via a complex remodel or by simple paint and wall covering — you are not alone. Since 1990, the number of telecommuters has grown at a rate of 15 percent a year mainly because of the convenience, tax and selling advantages.

In the days leading up to this year’s April 17 federal tax deadline (April 15 falls on a Saturday so the deadline is extended to the next business day) let’s check some of the reasons why working at home continues to make sense while there might be a recapture sting when you eventually sell.

It’s now relatively easy for taxpayers to deduct the cost of a home office. To qualify for a deduction, the space must be used exclusively and on a regular basis for either the entire business or its administrative and management activities.

The management provision was added in the Taxpayer Relief Act of 1997. It enables a home-office deduction to be available for any trade or business of the taxpayer as long as there is no other fixed location where the taxpayer “conducts substantial administrative or management activities of the trade or business.” The deduction is not curtailed if associates at other locations perform some management or administrative activities (such as mailings).

A home-office deduction is comprised mainly of depreciation, utilities and insurance. For example, if a home has 2,500 square feet and the detached garage, now deemed “the office,” is 250 square feet, then 10 percent of the utilities and insurance are deductible.

The actual office depreciation is 10 percent of what would be a depreciation deduction if the entire home were being depreciated for tax purposes. (Depreciation is not allowed on a typical principal residence, so the square footage allotted to “residence” would not qualify.) Supplies and other expenses directly related to the home office are fully deductible.

The area used for your home business can be depreciated using the 39-year depreciation method. The lower of your home’s adjusted cost basis or its market value on the day business use began can be the starting points.

However, all these benefits do come at a price. The tax law originally stated that if you sell your home at a gain any depreciation for a home office will have to be “recaptured.” That means that any profit on the business portion is taxable as capital gain.

On Dec. 23, 2002, the IRS issued new regulations concerning gain on home sales. As long as the home office was in the same structure and not separated from the home, only the depreciation taken for the home office after May 6, 1997, is subject to tax.

Here is the wording from the regulations:

“Taxpayers need not allocate gain between business and residential use if the business use occurred within the same dwelling unit as the residential use. They must pay tax on the gain equal to the total depreciation they took after May 6, 1997, but may exclude any additional gain on the residence, up to the maximum amount. If the business-use property was separate from the dwelling unit, they would allocate the gain and be able to exclude only the gain on the residential unit.”

In a capsule, if you bought your home for $150,000 and sold it for a net figure of $300,000, your capital gain would amount to $150,000. Because your office was in a separate and independent work shed, the business portion does not escape the new primary residence exclusions, so 10 percent, or $15,000 (the 250 square feet of office space), would be taxable.

Because depreciation can be confusing, it’s always best to consult an accountant or a tax attorney. The Internal Revenue Service’s Publication 587 “Business Use of Your Home” is accessible on the Internet at

Homes that can accommodate an office — perhaps converting an extra bedroom or garage — are becoming as desirable a selling point as any other home amenity. That’s because when potential home buyers intend to make a living from a specific space within the new home, they choose a home that meets both their living and working requirements.

While resale homes often have to be remodeled to include home-office space, many designers are helping builders with new plans that include one room that’s versatile and can be easily identified as a home office. In fact, some real estate agents say home offices sometimes help make or break a sale in a relocation situation, especially those involving double incomes and senior citizens.

Baby boomers and seniors are simply working longer. If you bring your office home, you could get hit with a recapture surprise.