Question: Can I avoid depreciation recapture by not claiming it before I sell?
Answer: Nice try. You may save yourself unnecessary worry and fear about so-called recapture, but it won’t save you any tax impact when you do sell. If you want to learn the truth about depreciation, keep reading to learn more.
More Interest Than Ever in Home Office Deductions
Whether due to the “work from home” popularity post-COVID, or the increase in side-hustles we learn about by watching Tik Tok, there’s more interest than ever before in home office deductions. According to a Pew Research study, nearly 59 percent of workers work from home.
Of course the disadvantages of TCJA (the Tax Cuts and Jobs Act) show up here as these workers wonder if there could be any tax breaks with their new office space in the home. For employees of third-party companies, there is no longer a deduction for unreimbursed employee business expenses.
While most employees won’t receive approval, it may be worth inquiring as to whether your employer would reimburse you for your home office expenses under an accountable plan. This works especially well if the employee is the employer. So, if you own the business, read on for tax-free payments from the business.
While some advisors may recommend simply having your business rent your home office from you, let me tell you why that can backfire – big time! When your business rents your home from you, you must include the rent in your taxable income when you personally file. That may not create additional tax, after all you generally can deduct expenses related to the rental thus offsetting the rental income.
However, special rules apply to owners of S corporations. (Don’t special rules always apply to S corporations?)
When you rent your home to your employer as an S corporation, you’re not allowed to deduct expenses attributable to the house during any period in which you use the home in performing services as an employee of the employer.[1]
Due to this specific provision, your S corporation may get the deduction for your home office rental. However, without your related home expense deductions, you’ll end up paying tax on that rental income as the employee owners.
Instead, consider using an accountable plan. When you make payments to reimburse for the home office under an accountable plan, you transform the payment from rental income to tax-free reimbursement.
Home Office Requirements
Just because you may be located at home while you are physically working, does not automatically entitle you to the home office deduction. You must first meet the exclusive use test and the principal place of business test.
Exclusive Use
So long as your home office is exclusively used for your business work, you meet this exclusive use test. However, most people don’t have the luxury of having an entire room dedicated to nothing but their work. Unfortunately, if your room is used for anything beyond the business, it will sabotage your deduction.
If you use your home office for crafts, or as a guest bedroom or even if you store personal items in it, you fail the exclusive use test. However, consider creating an exclusive use space within your living area if you live in a small home. Today there are many types of expandable desks, partitions, and room dividers which can offer you the ability to “put away” your office while you are not using it.[2] You may have to give up ever using that fancy sitting room or castle-like dining table, but your tax savings might be worth it.
Principal Place of Business
Many people mistakenly believe that if you have another office outside your home, it’s not deductible. However, the tax law tells us otherwise. So long as you use your home office for exclusively all of your business’ administrative or management activities, your home office qualifies as your principal place of business.[3]
Beef Up Your Expense Deduction
If you’ve got your records and know the costs to maintain your home, there are several ways you can increase the value of your tax write-off. The deduction is based on your business use percentage of the home. That is, you must divide your home between business and personal use.
Most people will simply take the square footage of the office space compared to the total square footage of the home in order to determine business use percentage. However, you can also try an alternate method and if your deduction is more with either method, you get to use whichever produces the greatest deduction.
The second method is the number of rooms method. If the rooms in your home are approximately the same size, take the number of rooms you use for business and divide by the total number of rooms in your home.[4]
In either case, you are permitted to remove spaces used as common areas like hallways, stairs, bathrooms, foyers, etc. This exclusion of space makes your business use percentage higher.
Is it Really That Simple?
In 2013, the IRS began allowing a new way to calculate your home office deduction. While the new method did not change the criteria for who may claim the home office deduction, it did minimize the amount of documentation to use it.
Known as the “simplified,” or “safe-harbor” method, if your home office square footage is 300 feet or less, you can simply deduct $5 per square footage of your home office space.[5]
It can be advantageous, especially if you can use some improvement (cough, cough) in your record-keeping skills. You don’t need any. In addition, you won’t have to reduce any of your other deductions such as mortgage interest or property taxes using this method.
The Truth About Depreciation
If you don’t use the safe-harbor method to calculate your deduction, you are eligible to deduct depreciation. Depreciation is an allowance for the wear and tear from using your home for business purposes. While you cannot depreciate the value of your land, you must recover any previous depreciation benefit you’ve received during your ownership. This is known as depreciation recapture.
Recapture is what makes some people uncomfortable. First, many believe that depreciation recapture will disqualify you from taking advantage of your personal residence exclusion. This simply is not true. There is nowhere in the law that suggests this[6].
A second misconception is that by forgoing the depreciation deduction, you don’t have to report any recapture. Again, this belief is untrue. In fact, you couldn’t exclude depreciation recapture after 1997. All allowed or allowable depreciation must be at the time of sale.[7]
The recapture is a Section 1250 gain, which is taxed up to 25 percent. Since you may have received a tax benefit greater than 25 percent (depending on your tax rate at the time taken), it can be a great way of shifting expenses to a lower income tax rate.
Depreciation allowed is what you actually claim throughout the business use life of your home office while depreciation allowable is what you could have claimed using a proper method[8].
So you see, if you’re going to pay a small price on the recapture whether you use it or not, make sure you claim the depreciation expense today. Your tax bill will be better for it.
