Today’s technology has made working from home a reality for many people. These individuals and their companies enjoy the benefits of reduced overhead and no commuting hassles. Another bonus: The IRS issued regulations on home sales that provide an unexpected tax bonanza for people who work out of their homes.
Under the home sale exclusion law, you can pocket up to $250,000 of tax-free capital gain from a sale of a home ($500,000 for joint filers).
To qualify, you must have owned and used the home as your principal residence for at least two of the five years prior to the sale.
Although this law was passed in 1997 and proposed regulations were subsequently issued, the IRS released final regulations five years later interpreting exactly how the law would apply in different situations. The current rules turned out to be much more generous than expected for taxpayers who use their residences for business purposes, such as a home office or rental.
Here’s an explanation of the change:
- Previous interpretation: If part of your home was used for business purposes before the sale, only the portion of the gain attributable to the residential use was eligible for the tax exclusion.
- Current IRS regulations: The entire gain from the sale now qualifies for the tax exclusion if the home office is located within the same dwelling unit. (Treasury Decision 9030) However, you must pay tax on the gain resulting from depreciation benefits claimed for a home office after May 6, 1997.
Let’s say you use 10 percent of your home as an office for your consulting business and you sell the residence for a $200,000 gain. The sale qualifies for the home sale exclusion.
Previously, you were required to pay capital gains tax on 10 percent of your gain for a tax bill of $4,000. Under the new regulations, the entire $200,000 gain from the home sale is tax-free. (Of course, you still must pay a 25 percent tax on any gain attributable to depreciation on the office space after May 6, 1997.)
The final regulations remove disincentives to claiming the home office deduction, provided your office or rental space is in the same dwelling unit as your principal residence.
Note that the exclusion does not apply to a home office or rental that is located in a detached garage or other separate building that is part of the property being sold. In other words, you will be taxed on gain from that structure.
New Option for Writing Off Home Office Expenses
The IRS announced a simplified option that many owners of home-based businesses and some home-based workers can use to figure their deductions for the business use of their homes. (IRS Revenue Procedure 2013-13)
The new option was effective Jan. 1, 2013 so it was be available for tax returns filed in 2014. It is an alternative to the current calculation, allocation and substantiation requirements. However, because the new option has limits, a taxpayer may get a larger deduction by continuing to use the current rules.
The optional deduction is capped at $1,500 per year based on $5 a square foot for up to 300 square feet.
Current rules: A taxpayer is generally required to fill out the 43-line IRS Form 8829. It may contain complex calculations of allocated expenses, depreciation and carryovers of unused deductions.
New rules: Taxpayers claiming the optional deduction will complete a different, simplified form. They cannot depreciate the portion of their homes used in a trade or business but they can claim allowable mortgage interest, real estate taxes and casualty losses on the home as itemized deductions. The deductions do not need to be allocated between personal and business use, as is required under the current method.
Important: The new option does not change the current restrictions on home office write-offs, such as requirements that a home office must be used “regularly and exclusively” for business and that the deduction is limited to the income derived from a particular business.
A taxpayer can elect from taxable year to taxable year whether to use the new method or to calculate and substantiate actual home office expenses. An election for any taxable year, once made, is irrevocable. “A change from using the new method in one year to actual expenses in a succeeding taxable year, or vice versa, is not a change in method of accounting” and does not require IRS consent, according to the new Revenue Procedure.
The new option will “reduce the paperwork and recordkeeping burden on small businesses by an estimated 1.6 million hours annually,” the IRS stated.
For more information about rules and regulations concerning home office expenses, please contact Tom Bailey via our online contact form.
Councilor, Buchanan & Mitchell (CBM) is a professional services firm delivering tax, accounting and business advisory expertise throughout the Mid-Atlantic region from offices in Bethesda, MD and Washington, DC.
