Sale of Residence with a Home Office

By Caryn M. Feldman, CPA, MST

If you see clients in an office located in your home, you must certainly be aware of the tax breaks available to you relating to your home office. But if you have been claiming home office deductions for a number of years, you may not be aware of a potentially expensive tax trap that can arise when it comes time to sell your home.

If you are planning on selling your home in the near future, you are probably assuming that there will not be a tax, thanks to the $250,000 ($500,000 if married filing joint) exclusion of gain on the sale of a principal residence. However, if you have a home office, or have taken home office deductions in the past, you may have an extra bit of planning to do in order to make sure you receive the full benefit of the exclusion.

Prior to issuing corrective regulations in December 2002, the IRS operated under the rule that if you used your principal residence for both personal and professional purposes, you would be treated as having sold two distinct properties for purposes of the home sale exclusion; a principal residence and a business property. Profit realized on the residence portion would be entitled to the exclusion, while profit realized on the business portion would be subject to tax.

Fortunately, the IRS recently fixed this problem. Current IRS rules no longer require most taxpayers who claim the home office deduction to allocate the gain between business and personal use if the business occurred within the same dwelling unit as the residential use. Instead, only the amount of depreciation you deducted in the past, as a home office expense will be subject to tax. Even more good news is that the more liberal application of the exclusion rules is allowed retroactively to all open years (i.e. those years still subject to the statute of limitations). This means that taxpayers who have fallen victim to the prior rules in recent years may be entitled to a refund.

If you plan to move or setup a home office in a free-standing garage, guest house or backyard bungalow, you need to think carefully about the tax ramifications. In cases in which your home office is not in the same building in which you reside, the old rules continue to apply and you may find you will lose out on a significant portion of your home sale exclusion.

Caryn M. Feldman, CPA, MST is a tax manager at Walter & Shuffain, P.C. located in Norwood, MA, a public accounting firm providing tax, audit and business consulting services to individuals and closely-held businesses. For more information on the sale of a residence with a home office, please call Caryn at 781-769-5300 or e-mail her at cfeldman@wscpa.com.