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As both examples illustrate, in the short term at least, when a business has a profit it's in the business owner's best interest to claim a home office deduction if they can. However, if a taxpayer's business is operating at a loss, or the home office deduction would reduce their profit below $0.00, the deduction will be limited to the business' net income, with the difference deferred to future periods. This effectively defers the home office portion of the home mortgage interest and the property taxes until the business has a profit or terminates. While it may be beneficial to stockpile such a deduction for one, two, or even more years, particularly for taxpayers in the 28% income tax bracket who are also subject to the full 15.3% SE tax, it becomes prohibitive over time to build up such an inventory of deductions if there is, or will be, no net income to claim them against.
In the long run though, the effects of the depreciation recapture rules under section 1250 can have an adverse long-term effect on what first seems to be a simple choice. Once the taxpayer qualifies for the home office deduction, they also qualify to depreciate their property under section 167. However, when a property is depreciated, under section 1016 the basis of the property must be reduced by the amount of the depreciation. The difference between the property's new basis adjusted for depreciation and its original purchase price is referred to as depreciation recapture. When a depreciated asset, real estate in this case, is sold for greater than its adjusted basis the amount of the sale that consists of depreciation recapture is either taxed at capital gain rates under section 1231, or ordinary income rates under section 1245 in the year of the sale. Fortunately, real estate is classified as section 1231 property and the depreciation is subject to capital gain rates. The situation is actually somewhat more complicated if the real estate was placed in service prior to 1985, involving the section 1250 rules, but we'll assume the taxpayer is considering beginning to use a home office in the immediate period. This effectively allows a taxpayer to exchange income and SE tax for a lower rate capital gains tax paid at a later date for the portion of the savings related to depreciation on the home.
To illustrate this, we'll use the previous two examples and assume both taxpayers have deprecated the relevant portions of their homes for all 39 years, resulting in a depreciation adjusted balance of $0.00 for the business portion of their home. We'll also assume both taxpayers only receive the original basis of their homes when they sell them (we'll address the effects of capital gain and the section 121 home sale exclusion later), resulting in a deprecation recapture, subject to tax at the same rate as the taxpayer's capital gain rate under section 1231. The taxpayer in the first example has taken $39K in depreciation deductions, has $39K in 1231 gain, has saved $9,569 in income and SE tax over the past 39 years (related to the deductions for depreciation), and will have a section 1231 tax liability of $1,950 in the year of sale, for a net tax savings of $7,619.00. In the second example the taxpayer has taken $39K in depreciation deductions, has $39K in 1231 gain, has saved $22,981 in income and SE tax over the past 39 years (related to the deductions for depreciation), and will have a section 1231 tax liability of $7,800 in the year of sale (a taxpayer in this bracket will likely be subject to the 20% rate on capital gains under the Alternative Minimum Tax), for a net tax savings of $15,181. In both cases it's still economical to take the home office deduction based on actual dollars saved, but neither example takes into effect the value of using inflation-diminished dollars to pay the tax liability. Few people will disagree that $1K in 1966 is worth considerably more than $1K in 2005.
Fortunately, section 121 can make section 1231 (and portions of 1250) a null issue. As originally penned under the proposed regulations it was an effective deal breaker for home office deductions, but it quickly became a paper tiger. Under section 121, a personal residence lived in as a primary residence and owned for two of the last five years can exclude up to $500K ($250K for single filers) of capital gain when sold, up to once every five years. As originally penned under the proposed regulations, if the portion of the home used for a business purpose does not also qualify under these rules, both the property and the gain exclusion must be prorated. This would mean, if 90% of the home used as a personal residence qualified, but 10% of the home did not, using the same figures from our previous example, not only would the taxpayer be taxed on the depreciation recapture, but only 90% of the gain, up to $450K, could be excluded, and 10% of the gain would be subject to capital gain without access to the exclusion. If subject to this situation in the year of sale, and a total gain of $500K is realized, the taxpayers in our two previous examples would be subject to a capital gain tax of $2,500 and $10K, respectably. Fortunately, when the final regulations were penned, the rules were simplified and the gain prorating issue, the effect of section 1231, and most of the effect of section 1250 were made moot. A residence that qualifies for treatment under section 121 is not required to recognize any gain other than section 1250 recapture earned after 1997 (a comparatively rare instance), regardless of income type. This means, in short, that as long as an individual's residence sale qualifies for section 121, and the property hasn't been depreciated at greater than straight-line rates since 1997, no amount of the gain, up to $500K (and prorated evenly by type thereafter) will be exempt from taxation. This effectively gives the taxpayer something for nothing, a deduction against current income now, with an exemption from the gain recapture later.
Some individuals attempt to circumvent this issue by not claiming the depreciation, but taking the other expenses, attempting to avoid the depreciation recapture. Unfortunately, this creates a bigger problem then it solves. Under section 1016, a taxpayer is required to reduce their basis by the amount of depreciation they would be entitled to, regardless of whether they actually take the deduction. Also, regardless of whether or not a taxpayer takes the depreciation on their property, once it qualifies for business use it will be subject to the recapture rules under section 1231 and 1250. As such, in an effort to circumvent a long-term issue, individuals who chose this path deprive themselves of years of depreciation deductions and fail to skirt the issue they intend. Fortunately, there is some relief for individuals who've previously made this error by filling an automatic accounting method change under rev proc. 99-49.
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