If you have a small business, the taxes can be pretty tough to swallow. That’s why you need to be sure that you take all the tax write offs you possibly can to lower your small business tax bill. These small business tax deductions are particularly important for solo entrepreneurs and other self-employed business owners who get stuck with additional self-employment tax. For many business owners, one important tax deduction is the home office tax deduction. This deduction allows home owners who use part of their home for business purposes to write off expenses including deducting property taxes, a portion of utilities and other costs of owning and maintaining a home.
How Home Office Affects Capital Gains on Home Sale
When you sell property, like your home, you typically have to pay taxes on any increase in the value of the asset. These taxes are called capital gains taxes. Fortunately, these taxes are often taxed at a lower tax rate than your standard tax bracket rate. Unfortunately, on the sale of a large asset, like your home, these capital gains can still be substantial. Luckily, there is a special home sale exclusion for capital gains on the sale of your home.
Assuming you meet all the criteria for the home sale exclusion, you can exclude $250,000 if you are filing single, or $500,000 if you are married filing jointly on the sale of your personal residence. For example, if you bought your home for $250,000 and then sold it several years later for $450,000, you would typically owe capital gains taxes on $200,000. However, with the exclusion for home sale capital gains, you wouldn’t have to pay taxes on any of it.
There is a wrinkle in this home sale capital gains tax break for small business owners who claim part of their home for a home office tax deduction. If you check the your home office deduction form, or Form 8829 filed with your Form 1040 every year, you’ll notice that part of your home office deduction comes from the depreciation of your home. This part of the deduction falls into a lesser known part of the IRS tax code. The IRS rules for depreciation of your home office during a home sale, state that this depreciation must be recaptured.
Recapturing Home Office Depreciation When Selling Your Home
The part on your home office deduction form listed as depreciation is a tax deduction for the wear and tear on your house. Assuming you are using an accountant, or tax preparation software such as TurboTax, you most likely have taken at least some amount of depreciation as part of your home office tax deduction each year. Look for Form 8829: Expenses for Business Use of Your Home on Part III, Line 41. You’ll see Depreciation Allowable. That’s the amount you claimed as depreciation of your home for your small business home office.
When you sell your home, the IRS requires that you pay taxes on this amount through something called unrecaptured gain. In particular, this kind of depreciation is unrecaptured 1250 gain. The unpleasant part is that this type of recapture is taxed at 25% rather than the much lower standard long-term capital gains rate of 15%.
What does this mean for you and your small business?
If your small business is profitable, and you are paying taxes on your small business via the trusty Schedule C tax form, then the deduction you are getting from your home office likely is just as much, or more than you will end up paying when you sell your home. The difficulty however, is that if you have claimed a large home office, for a long period of time, this tax can be pretty hefty, and it is due all at once, in the year you sell your house.
If your small business operates at a loss, or if your total income is low enough that your tax rate, plus any self-employment tax, adds up to less than 25 percent, you MAY not be coming out ahead on this tax. If your business is new, and you expect to sell your home in the near future, be sure to carefully evaluate if the home office deduction is right for you.
In the end, most tax professionals recommend taking every deduction you can during every tax year, in part because you never know how the rules will change over the years, and you cannot reliably predict your tax situation in the future.
There is a new option for the home office deduction starting in 2013. According to IRS rules, tax payers with a home office can take a flat rate deduction instead of calculating the traditional home office deduction amount. When taxpayers use this method, none of the flat rate is considered to be depreciation. A smart tax strategy is to calculate both methods for your home office and then choose the higher one. If they are similar amounts, it may be advantageous to claim the flat rate amount and not get the depreciation part of the home office tax write off added to your unrecaptured gain.