It is not unusual for clients to use part of their house for an office. Many senior citizens use spare rooms, basements, or other areas of their house in a home based business to supplement income. As many clients are forced to defer retirement, or return to work on a part-time basis, the use of home offices will likely continue to grow. When selling a house that has partially been used for an office your clients are not able to exclude the portion of the proceeds applicable to the sale of the home office. They will not be able to qualify that portion of the house for the home sale exclusion of $250,000/$500,000. The home office is a business use of the property, not a principal residence use. Therefore, it cannot qualify for the favorable home sale tax rules.
POINTER: When clients sell a house that has been used for another purpose, analyze the situation “as if they were selling two separate properties: (1) their house, which may qualify as a personal residence and for the home sale exclusion of $250,000/$500,000 (or under prior law, the tax-free roll over rules or $125,000 exclusion); and (2) a home office, which is a separate business property that cannot qualify for the principal residence exclusion. Allocate the price the clients will receive for the sale of the house between the residential portion of the house and the business use portion of the house. The ratio to make this allocation should be the same ratio that the clients’ accountant has used to allocate various house related expenses between the clients’ home office (often reported on Schedule C of the clients’ personal income tax return Form 1040, with respect to a home based business) and personal itemized deductions (reported on Schedule A). Form 8829, “Expenses for Business Use of Your Home,” which the clients’ accountant will prepare for filing with the clients’ tax return, should reflect the calculation of the appropriate percentage.
The tax consequences for each “property” can then be separately determined. In most instances, practitioners should have the calculations made, or at least reviewed, by the clients’ accountant. An example can illustrate the calculation. Assume that one bedroom in a house was being used by the clients on an exclusive and regular basis as a home office, and that the use of the room met all requirements to qualify for a tax deduction. Allocate 10 percent of the qualifying costs to the home office, since it utilizes approximately 10 percent of the floor space in the house. Assume the house was purchased for $100,000 (consult the HUD-1, RESPA statement from the purchase, but be certain to add in all ancillary purchase costs to the contract price). The clients’ accountant, therefore, allocated 10 percent, or $10,000, of this amount to the home office on which they calculated annual depreciation (modified accelerate cost recovery) deductions. Total depreciation deductions for all years was $3,500. The tax basis for the remaining 90 percent of the house is $90,000 ($100,000 $10,000). The clients then sell the house for $150,000. The home sale exclusion would, assuming the requirements are met, avoid any gain on the residence portion. The business use portion must be addressed separately. The tax consequences of the business portion of the transaction are as follows: Old House Office Portion: Sales Price [$150,000 x 10%]$ 15,000 Less: Tax Basis: ((Cost of 10% x $100,000) $3,500 depreciation) 6,500 Taxable Gain $8,500 Tax Rate (est. 20% federal + 5% state) x 25% Tax $2,125
There is a way, in some situations, to avoid gain on the business/rental portion when the client is selling a house that is both a personal residence and a business property (either a home office or a rental). It may be possible to arrange a transaction where the client can effectively use the home sale exclusion to avoid gain on the residential portion, and separately use a tax deferred like kind exchange to defer the gain on the business portion under rules that permit a tax-free (deferred) exchange of property used in trade or business or held for investment.
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