Beat the Recapture Tax on Your Home OfficeTax Planning
Do you claim the home-office deduction?
As you likely know, the depreciation you claim with your home-office deduction is subject to a recapture tax when you sell your home.
How would you like to not pay the recapture tax? You can do just that with one easy step that you learn in this article.
But this gets even better. When you use this one easy step to sell your home, you not only avoid the recapture tax but you also increase your tax basis in your replacement home. This gives you a double dip in tax benefits.
First, say “thank you” to the IRS for creating an easy-to-follow procedure for combining the tax-favored Section 1031 tax-deferred exchange2 and the Section 121 home-sale exclusion3 rules so that you can sell your home and
- avoid taxes on the sale of the personal part of your home,
- avoid taxes on the sale of the office part of your home,
- avoid taxes on the sale of the rental part of your home, and
- defer taxes on depreciation recapture caused by the office or rental part of your home.
Think of it: zero taxes this year when you use the right combination of Sections 121 and 1031. You can use this combination to defer and avoid recapture and capital gains taxes on a principal residence
- in which you claimed a home-office deduction, or
- that you used as a rental property.
Tax knowledge is powerful stuff! Taxpayers with home offices who are in the know will stop selling their homes and start using 1031 exchanges.
The word “exchange” in Section 1031 is misleading. To create an exchange under this section of the law, you “sell” your old property and “buy” a replacement property.
Note the words “sell” and “buy.” To get the tax-favored treatment, you simply engage an exchange intermediary such as Wells Fargo Bank, IPX1031, etc., that
- creates the paperwork that allows you to sell your existing principal residence, and
- creates the paperwork that allows you to buy your replacement residence.
Think of the intermediary as a puppet: you hold the strings and tell the intermediary exactly what you want.
With little effort, you can set this up so you notice almost nothing, except the tax-favored treatment. And the right intermediary might do all the work for a fee of $1,000 or less.
And It Gets Even Better
Avoiding and deferring taxes is impressive.
But the combination of Sections 121 and 1031 has an even more impressive side. Imagine this:
- Use the home-sale exclusion to generate $50,000 of tax-free profit on the office part of the sale.
- Take that tax-free profit and add it to the basis of your home office in the replacement residence.
Now that’s impressive! It doesn’t get much better than this: having your tax-free gains turn into additional basis, which means
- free depreciation deductions, and
- reduced taxes on the next sale.
This is a classic example of having your cake and eating it, too. Let’s examine how this works.
Principal Residence Tax Avoidance Rule
In general, when you sell your home, Section 121 grants tax-free treatment to gains of up to $250,000 (single) or $500,000 (married) if you both
- used the home as your principal residence for any 24 of the 60 months before the sale, and
- owned the home for any 24 of the 60 months before the sale.
Home-Office Location Rule
Your office in the home may be within the walls of your home or outside the walls, such as in a guesthouse or above a detached garage.
Office within the Walls
The IRS applies Section 121 tax-free treatment to the gain on an office inside the walls of the dwelling unit. Thus, if one-third of your house is office space, you may apply one-third of the $250,000 or $500,000 exclusion to the home-office profits.
Example. The office, which you have claimed as a deduction for each of the past 10 years, resides within the walls and takes up one-third of your dwelling. Ignoring depreciation recapture, which we discuss below, you and your spouse sell this home for a $300,000 profit and use the Section 121 exclusion to
- make $200,000 of the home-sale profit tax-free, and
- make $100,000 of the personal-office profit tax-free.
Your home appreciated by $300,000, and you have $300,000 of tax-free profit (gain). So far, excellent—but it can get even better.
Next, you must consider the depreciation recapture tax (generally 25 percent) on the depreciation that you claimed on the office part of your home.
No problem. As we mentioned above and as we will amply show below, simply use the 1031 exchange to defer the recapture taxes.
Office outside the Walls
You may not apply the Section 121 $250,000/$500,000 exclusion to any profit on the sale of an office that’s part of your personal residence but outside the walls of the dwelling unit.
Example. For the past 10 years, you’ve had an office in the guesthouse, which is on your property about 13 feet from the main house. You sell this property, including the guesthouse, for a $300,000 profit. The guesthouse makes up one-third of the property. You and your spouse
- may use the Section 121 exclusion to make $200,000 of the home-sale profit tax-free, but
- may not use any of the Section 121 exclusion on the $100,000 of home-office gain.
With no plan, you are in a pickle. You have $100,000 of taxable gain on the guesthouse plus depreciation recapture.
The plan. Use the 1031 exchange as we explain below to defer taxes on both
- the taxable $100,000 profit from the sale of the guesthouse, and
- the depreciation recapture attributable to the guesthouse.
In summary, when you have a home office, inside or outside the dwelling, Revenue Procedure 2005-14 shows you the following:
- How to use the 1031 exchange to defer the depreciation recapture tax (which applies to home-office depreciation claimed after May 6, 1997)
- How to use Section 121 to make the gain on the office part of the home tax-free
- How to use the 1031 exchange to defer taxes on the home-office gain to which Section 121 does not apply (such as the office in the guesthouse)
Applying the Procedure
Revenue Procedure 2005-14 contains six examples. We are using the third example to illustrate the benefits of the combined strategy.
Facts. Say you bought your home in 2003 for $210,000. You have used one-third of the building as an office and the other two-thirds as a residence. Today, the home is worth $360,000 and carries $30,000 in depreciation subject to the recapture tax.
Outcome. With the application of the Section 1031 rules under Revenue Procedure 2005-14 to the sale of this home for $360,000 and the purchase of a replacement for $360,000, you
- avoid capital gains taxes on $150,000 of gain,
- avoid the recapture tax on the $30,000, and
- increase your basis in your new office by $50,000.
The table below shows how you realize the benefits of this strategy
Look at the Office column (on the right). Note that you sold the office for $120,000, had $80,000 of gain ($120,000 minus $40,000), and then used Section 121 to exclude $50,000 from taxes and Section 1031 to defer $30,000 from taxes.
Next, look at the Home column (in the middle). Note that you sold the home for $240,000, realized a gain of $100,000 ($240,000 minus $140,000), and applied $100,000 of the Section 121 exclusion to avoid taxes (pay zero) on the gain.
Revenue Procedure 2005-14 requires that you apply Section 121 before applying Section 1031. Excellent! You get the tax-free part first, and that’s a big part of what makes this work to your advantage.
Take a look at the table below. Look at the Office column. See how you add the $50,000 from the gain on which you paid no taxes to the $40,000 adjusted basis—to get a new $90,000 basis in the replacement office?
Let’s look at this $50,000 in a different light. Say you pay taxes at the following federal rates:
- 15 percent on capital gains, and
- 33 percent on ordinary income.
Section 121 applies the office part of the exclusion to the $50,000 of capital gain attributable to the home-office part of the sale, because the office is within the walls of the dwelling. That saves you $7,500 in capital gains taxes.
Next, you depreciate the $50,000. That saves you $16,500 in ordinary income taxes. This little gift puts $24,000 in your pocket. Thank you, tax knowledge.
If you claimed a tax deduction for an office in your home and it’s now time to replace your home, make sure to spend a few moments planning your replacement. With tax planning, you generally add cash to your bank account.
Revenue Procedure 2005-14 is powerful stuff. It illustrates how the use of Sections 121 and 1031 can produce spectacular results in which you
- avoid taxes on the sale of your home,
- avoid taxes on the sale of the home-office part,
- avoid taxes on the sale of the rental part, and
- defer taxes on the depreciation-recapture part.
To get the tax-favored treatment, your first step is to engage a real estate exchange intermediary. Go to the Internet and search. You will find many local and national real estate exchange intermediaries. Do some shopping.