The eventual, and often unexpected, tax cost of home office depreciation
Saturday, March 31, 2012
Since I didn't win the Mega Millions lottery, I'm back at work. And as a self-employed entrepreneur, the bulk of my work is done from my residential workspace.
Once viewed as an audit magnet, a growing number of home-based workers have overcome their tax examination fears and claimed the home office tax deduction.
By doing so, we get to write off on Schedule C a portion of our household expenses, including mortgage interest, maintenance, real estate taxes, insurance and utilities.
Our home offices also can be depreciated, adding to our tax savings. The pros, cons and a tax surprise connected to home office depreciation is Today's Tax Tip.
Why and how to depreciate: Depreciation of business assets is a common tax-saving move.
When a business property or asset has what is known as a useful life of more than a year, it typically is depreciated. That is, the cost of the asset is spread across several tax years with a portion of the total cost deducted each year.
When it comes to home office depreciation, the tax recovery period is 39 years using the straight line method of depreciation and a mid-month convention.
Yeah, I heard your head exploding as you read that last sentence, taken directly from the IRS website. And that IRS direction leads to a confession. The first time taxes drove me to tears was in 1982 when I tried to calculate depreciation. Thank God for tax software!
A very simple, down-and-dirty guide is that you multiply your home's value plus any improvements by the percentage of business use of your home to arrive at the amount you can depreciate. For example:
Your home office represents 10 percent of your home's square footage. The value of your home is $200,000. Dividing the residential value by the 39-year recovery period gives you $5,128 and 10 percent of that amount gives you a $513 depreciation deduction for the home office.
That $513 is added to all your other home office deductions.
Recapturing home office depreciation: Even with help from a tax professional or tax software, you decide it's not worth the hassle to claim depreciation on your home office.
You might want to rethink that. The IRS is going to make you pay for the home office depreciation when you sell your house even if you didn't claim it.
That's right. The law says that you must depreciate your home office to claim all the other home office deduction benefits. And that means that if you claimed all expenses except depreciation, you would still have to account for depreciation when you sell.
I hear you. Homeowners are able to exclude from taxation up to $250,000 in profit if they're single or $500,000 for a married couple that files jointly. But that exclusion applies only to the profit on the personal use of your home.
But because you used part of your house for business, that amount must be, in tax parlance, recaptured at the rate of 25 percent.
Based on the earlier example, you had a home office for 10 years and depreciated $513 each year, you'll owe recapture tax on the total depreciation of $5,513, resulting in a tax bill of $1,378.
Allowed or allowable: And even if you didn't claim the depreciation, just the mere fact that you could have claimed it means that you owe tax on it. Depreciation is considered as either allowed, meaning you took it, or allowable, meaning you could have claimed it.
IRS Publication 946, How to Depreciate Property, says:
You must reduce the basis of property by the depreciation allowed or allowable, whichever is greater. Depreciation allowed is depreciation you actually deducted (from which you received a tax benefit). Depreciation allowable is depreciation you are entitled to deduct, you must still reduce the basis of the property by the full amount of depreciation allowable.
And IRS Publication 587, Business Use of Your Home, says:
If you used any part of your home for business, you must adjust the basis of your home for any depreciation that was allowable for its business use, even if you did not claim it. If you deducted less depreciation than you could have under the method you properly selected, you must decrease the basis by the amount you could have deducted under that method. If you deducted more depreciation than you should have under the method you properly selected, you must decrease the basis by the amount you should have deducted, plus the part of the excess deducted that actually decreased your tax liability for any year.
Basically, allowable depreciation is forced on you by the IRS, sort of like the limits on some tax breaks on a person who could be claimed as a dependent even though no dependent claim was made by another taxpayer.
That means that even if you don't depreciate your home office and when you sell and make a profit, you'll have to recapture the allowable depreciation.
So if you're taking the home office deduction, go ahead and take the depreciation since you'll owe the recapture tax when you sell. And at least the depreciation will save you some tax dollars now.
Home offices in black and white: No, that photo at the top of this post, courtesy ChicTip.com, is not my home office. It's much too modern, organized and, well, white.
I'm a New Yorker when it comes to attire and most of my home office furnishings.
That's me over there at the right, clad in de rigueur NYC black, toiling away at my dark-hued PC.
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Great article. First one I've found that actually explains the automatic assumed depreciation if you claim a home office. Thanks!
Posted by: massguy | Tuesday, February 26, 2013 at 11:33 PM
If the renovations were carried out after purchase then a separate report will be required. Alternatively the receipts can be handed over to your accountant for them to claim separately.
Posted by: tax schedule depreciation commercial | Saturday, April 14, 2012 at 06:35 AM
I believe you will pay that recapture tax only if you make a profit on the sale of your home. Not that many people doing that lately.
Posted by: zzz wtn | Tuesday, April 03, 2012 at 12:51 PM
Thank you, Kay!
Posted by: Randall K | Saturday, March 31, 2012 at 02:12 PM