Sale of Home Partly Used As a Business Office

As tax laws go, the rules are fairly straightforward when it comes to figuring taxes on profits from sales of personal residences. But the rules become convoluted when the home in question partly serves as a business office. Below is my response to a representative question from home sellers who operate businesses out of their residences.

Q. Within the next few years, I plan to sell my home. I use one of its rooms only as a home office for my business as a freelance writer. I have been claiming office-at-home deductions for a proportional share of depreciation and other expenses associated with the room's business use, just as I have been writing off all the equipment and furniture stuffed into the office. How do the tax rules work when I sell my home?

A. Prior to 2002, the rules were tougher if you used part of your residence for business purposes and then sold your home. Yes, the law allows an exclusion -- an escape from taxes -- of profit from sale of a principal residence. The exclusion amount generally is as much as $250,000 for single persons and married couples who file separate returns and $500,000 for married couples who file joint returns. But those rules authorized an exclusion only for the portion of the profit attributable to the residence part, prohibiting any exclusion for profit on the office part.

In effect, the IRS treated this kind of sale as if there had been a sale of two pieces of property -- one a residence and the other business real estate. Consequently, the seller had to make separate calculations for the residence and business profits, dividing the selling price, selling expenses and basis between the residence and business parts.

The IRS scrapped the old rules and replaced them in 2002 with new ones that do away with an allocation between residence and business. The sale is a single transaction as long as the home office and the residential part are both within a single residence or, as the regulations put it, "dwelling unit." Accordingly, someone like you can exclude the entire profit, despite using part of the home for business.

This break is subject to a "recapture" restriction designed to prevent a double benefit. You forfeit any exclusion for the part of the profit equal to any depreciation deductions allowed or allowable on the home office after May 6, 1997. Instead, you pay taxes on that part. (Allowed or allowable means what you claimed previously or, if you claimed less than you could have claimed, the amount that you could have claimed.) In this regard, the new rules do not differ from what the old rules obliged you to do.

This restriction lets the IRS recapture depreciation write-offs that you used to lower taxes in pre-sale years. The agency still applies the recapture rules even if you cease to use that room for business reason and the entire home is a principal residence for at least two years out of the five-year period that ends on the sale date.

For recapture not to apply, you have to show by "adequate records or other evidence that the depreciation deduction allowed was less than the amount allowable." Then the amount that "you cannot exclude is the amount allowed." (Usually, past returns should satisfy the requirement for adequate records -- another reason why it is advisable to save copies of returns.)

To illustrate, assume that your home office qualified you to claim depreciation, but you can show that you never claimed any. Then there is no reduction of the exclusion amount and no recapture.

Recaptured depreciation is taxed at a maximum rate of 25 percent instead of the top rate of 15 percent for long-term capital gains, plus applicable state income taxes. As for the inescapable paperwork, the place for you to report the recaptured amount is Schedule D (Capital Gains and Losses), not Form 4797 (Sale of Business Property). On the plus side, you suffer no recapture of other expenses like real estate taxes and mortgage interest.