Don’t let home office tax deduction tales haunt your house

Another IRS mystery solved

With the U.S. labor force continuing its substantial shift toward an entrepreneur-freelance-self-employed economy, more and more people find themselves working from a space in their homes. And why not? Working from home is easy, convenient, cost-effective and hey, it could even keep you from having to fork over more money to Uncle Sam every April 15 by allowing for the home office deduction on your income taxes, which can be one of the most lucrative tax deductions you can take.

However… rumors and mystery swirl around this deduction.

You might have heard that the Internal Revenue Service (IRS) specifically targets people who take the deduction for audits. So you wonder if you should consider taking this deduction, given that you don’t want to be dragged through the bureaucratic wringer.

In addition, someone may have told you that taking the deduction could come back to haunt you when sell your home, since it will cause the home to depreciate in value. Is that true, or is there more involved than the IRS saying that you will owe money on the sale of your home?

The home office deduction defined

Simply put, the home office deduction allows you to take a percentage of the indirect and direct costs of your home office and deduct them as an expense of your business. The percentage is calculated by dividing the square footage of your home office by the total square footage of your home.

Example: You live in a 2,000-square-foot home and your office is 200 square feet. You’d be able to deduct 10 percent of your mortgage/rent, utilities and other home-related expenses under the home office deduction (i.e., 200-square-foot office/2,000 sq. foot home = 10 percent home office deduction).

Why the IRS flags the deduction

So why does the IRS target the home office deduction? The big reason is that it’s an easy win for the agency, as they can disprove the legitimacy of your claim if not supported. They aren’t looking at everyone who takes the deduction, but they do check to see if the amount of the deduction is out of whack.

For instance, let’s say you earned $50,000 designing websites, and you took a deduction of $30,000 for your home office. Even if you could legitimately claim that amount, the IRS would want to take a close examination of your records to see if you’re doing something you shouldn’t be.

To combat this scrutiny, make sure that you can legitimately claim all of the items that go into your deduction. Also double check the square footage of both your house and home office space. An improper percentage could drive up the deduction and get you flagged for an audit.

The impact on your pocketbook

So does taking the home office deduction reduce the value of your home? The basic answer is yes — to a certain extent. Here’s what happens.

First off, keep in mind that when you take the home office deduction, you can include some depreciation on your home as part of that deduction.

The profit on the sale of your home up to $250,000 is not taxed if you’re filing as a single person ($500,000 if married filing jointly). This is the exemption amount the IRS gives you. If your profit is greater than the exemption amount, you’ll have to pay capital gains on the amount greater than the limit, usually at a 15-percent tax rate.

When you calculate the profit from the sale of your home, you’ll need to reduce your basis in your home (what you paid for your home plus or minus a few adjustments) by the amount of depreciation taken on your home office. This might increase the profit on the sale of your home, which would cause you to have to pay capital gains taxes.

As a result, for any depreciation deductions you took after May 6, 1997, you will have to pay a capital gains tax of 25 percent on the deductions. Fortunately, if your tax rate is less than 25 percent, you’d be taxed at the lower rate.

Even if you don’t end up going over the exemption amount, you might still have to pay some taxes when the government “recaptures” the tax on the depreciation of any business use of a sold property. This is reported on Schedule D of your tax return, which is used to show all your capital gain transactions — otherwise known as “unrecaptured Section 1250 gain.”

This is done because you used your property for both business and residential purposes. You would be taxed at a rate of 25 percent, regardless of your ordinary tax bracket.

But what if you don’t claim depreciation on your home office?

What if you just claimed exemptions for the space and the proportionate costs for rent and mortgage payments, as well as utilities and maintenance? Do you still have to pay taxes on an unrecaptured gain?

Unfortunately, the answer is yes.

According to the IRS, the unrecaptured Section 1250 applies to depreciation whether or not you took it. So since you’re going to have to pay the tax, you may as well get the benefit of the deduction.

While there’s always a chance you could be audited if you take the home office deduction, and you could get dinged for taking the deduction when you sell your house, don’t let that stop you from considering taking the deduction for the home office you use for your business.

Good tax planning can help mitigate the taxes that you’d have to pay and reduce the chance of an audit. If you’re unsure about taking the deduction, talk to an accountant for guidance.  They’re always willing to help solve the riddles of the Internal Revenue Code.

The above content should not be construed as legal or tax advice. Always consult an attorney or tax professional regarding your specific legal or tax situation.