Saturday, January 14, 2006

You can't win - the trap of the home office depreciation

On the advice of an accountant, I depreciated my home office. Bad mistake. When you sell, there are lots of headaches. Grrr. The infuriating part is that if even if you deducted expenses, but not depreciation, the IRS taxes you as though you claimed the depreciation.

Between Digital Rights Management and the IRS I'm ready for a life of crime.
Depreciation Appreciation 101: The Ins and Outs of Deducting for a Home Office - New York Times


... The I.R.S. allows you to take a home office deduction if you meet certain conditions, and about 30 million taxpayers manage to meet them. The rules are pretty clear for the self-employed. The home office has to be the primary place of business, used exclusively and regularly for that business. If your office fits that definition, you can write off a percentage of the utilities, the mortgage, repairs and maintenance and, of course, all the office equipment and furniture stuffed into it.

... when you sell your home for a profit you have to recapture the depreciation you took on that office and pay taxes on it. For example, say you bought a house for $500,000 and used 10 percent of it for an office. (You figure that out by measuring the square footage of the office and dividing that by the square footage of the entire house.) You are allowed to depreciate 10 percent of the purchase price of the house each year using what the government succinctly calls the "39-year commercial property straight time depreciation schedule." That adds up to about $6,000 in depreciation over five years.

You later sell the house for $750,000. The $250,000 in profit is excluded from tax. But the $6,000 you took in depreciation over the years must be reported as a gain on Schedule D, in the gains and losses section. It is taxed at a 25 percent rate.

What if you take other home office deductions and skip the depreciation? Nancy Mathis, an I.R.S. spokeswoman, says that will not help. "Even if you don't take this depreciation, it will be treated as if you did when it comes times for calculating the basis of the home sale and capital gains exclusion." The I.R.S. will not say why it makes that assumption, but accountants surmise it is because the government cannot keep track of home-office owners who might depreciate some years and then stop right before selling in hopes of avoiding the extra tax.

Here's something to think about: If you rent, you avoid this entire frustration when claiming a home office deduction.

Now for the more complicated question: Remember that the government allows a single person to exclude $250,000 of capital gains on a home sale and a married couple, $500,000. If you claimed 10 percent of your home as a home office and wrote that off over the years, when you sell the house, do you owe capital gains tax on 10 percent of the profit? This is what is tripping up Mr. Sigal, the chemical engineer.

The government used to say, you owe the tax on the portion of the residence that is used for commercial purposes. But it gave taxpayers a little gift when a new rule took effect in 2002. The home office inside the structure of your house is no longer considered commercial property. Everything is covered under the capital gains exclusion. If your accountant is not up to date on that, ask him or her to check it out.

Indeed, Mr. Sigal does not owe as much as he was told and a new accountant confirmed that he owes taxes on only the $2,000 of recaptured depreciation.

But in changing the rules, the I.R.S. also made things more complicated. Funny how that happens. That no-tax rule applies only if the home office is part of the structure of the main residence. "If it is a separate building," said David Gitel, a New York City tax accountant, "you are out of luck." When you work out of a detached garage or shed, you must compute the profit that is attributable to that structure and pay a capital gains tax of 15 percent on it, plus the tax on the depreciation recapture.

In that case, what you can do is make what is called a 1031 exchange. Don't do it without guidance from an accountant, but buy another piece of commercial property within 190 days and you can avoid paying taxes.

Given how complicated it is, many people might ask whether it is worth the bother to deduct a home office on Schedule C, the form for private businesses. Would it be easier to just write off most of the expenses as nonreimbursable business expenses on Schedule A?

You probably are deducting your interest payments and your property taxes on Schedule A anyway. The benefit to using Schedule C - you'll need two other forms, 8829 and 4562 - is that the mortgage, the taxes and other costs of running the home office decrease the income you made from your home-run business. That means there is less that is assessed the 15.3 percent self-employed Social Security tax. "You get more out of it on Schedule C," Mr. Gitel said.

But if you don't qualify for a home office, Schedule A is the place to deduct business expenses. A good tax accountant will make easy work of this. Tax software, like the Premier edition of TurboTax, can do it, too, and will also walk you through the process of depreciation recapture in a series of interview questions.

You can deduct other things if you have a home business. In addition to a share of utility bills, you can deduct an extra phone line, any business equipment you buy or the business use of the car.

You can hire your spouse as an employee and provide medical insurance. He or she puts you on her medical plan and your business swallows the cost as a business expense, reducing your taxable income. Retirement accounts for private businesses are also quite generous and another good way to shield income.

As for Mr. Sigal, he has a home office in his new condo. But this time he is cutting his taxes by deducting business expenses that were not reimbursed by his employer.
In Minnesota, when you sell, you're asked if you ever took the home office deduction. I'm told savvy people give the same answers as Judge Alito -- I can't recollect that.

I do like the bit about the spousal insurance though.

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