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May 2019 Tip of the Month


Abo and Company knows a great tax planning opportunity when we see one and, when the proper stars line up, we’ve often suggested clients avail themselves of the benefits of claiming home office deductions. However, there is tax trap we were just reminded of this week.

Before we get into such, we recommend you read our February 2019 “Tip of the Month”.

The possible downside? Well, you should have learned from us that when you sell your principle residence, if you meet fairly straight forward requirements, you should be able to exclude most, if not all, of the resulting taxable income from the sale. If you have used your house as your principal residence for at least 2 of the prior 5 years, you can exclude from the capital gains tax $500,000 of the gain if you are married filing jointly or $250,000 if you are a single taxpayer.

Well, here’s one bummer we often cite…if you took home office deductions previously, you have to recapture the depreciation on the office portion when you sell the house. Not only that, this depreciation recapture income will be taxed at a rate higher than the preferential long-term capital gains rate.

As we pointed out in our February 2019 tip, if you use the home office regularly and exclusively as (1) your principal place of business (i.e., the place where you conduct most of your income-earning activities or the place where you conduct all your administrative chores) or (2) a place where you meet with customers, clients or patients in the normal course of business, you can deduct direct expenses for your home office plus a proportionate share of indirect expenses like mortgage interest, property taxes, utilities, repairs and insurance. In addition, you can claim a depreciation deduction for the part of the home used as an office.

A bummer but you have to give up some of that home sale gain exclusion and pay tax on that portion of the gain equivalent to depreciation deductions for the home office since May 6, 1997. While the max long-term capital gain rate for high income taxpayers, the real estate depreciation recapture is taxed at a 25% maximum. Often overlooked is the concept in depreciation of “allowed or allowable” where you will need to recapture the depreciation you could take regardless if you never actually took it.

Sooo…. does this translate into forgoing home office deductions? The continuing tax benefits from deducting direct home office expenses, allocable depreciation and a portion of indirect expenses will often dwarf the tax incidence that depreciation recapture might bring later. Having to pay a 25% tax on the depreciation deductions you took over the years before you sold your house is no more, and often less, than the tax you would have had to pay if you didn’t take the deductions in the first place and instead paid tax on your additional taxable income at ordinary income tax rates (plus possibly the self-employment tax which can often approximate an additional 12%). Don’t forget there is no recapture on all the other non-depreciation deductions you claimed.