Hamill: The tax twist when you sell a home with an office

Question: I own a house that is 2,857 square feet. During COVID, I started to work exclusively from my home, and I began to claim a home office deduction on my tax return. I am planning to retire later this year and place the home on the market with the goal of moving to an independent living facility. I bought the home in 1991 and should have a fairly large gain, but since I file a joint return with my wife, I expect that I will not pay any tax on the gain because of the $500,000 tax exclusion allowed by the IRS. My question relates to the office portion of the home. I am not clear how that will affect my taxes when I sell the home.

Answer: This can be a surprisingly difficult question because the answer depends on exactly how you have claimed the expenses for use of the office.

The starting point, as you note, is the rule that allows you to exclude as much as $500,000 of gain from the sale of your home. This rule requires that the home be owned and used as your principal residence for two of the five years before sale. You qualify on that point.

The exclusion amount is generally $250,000, but is increased to $500,000 if you file as married filing jointly and both spouses used the property as a principal residence.

A straightforward sale would not involve any use of the property for reasons other than residential use.

In your case, the property was always used as a residence, but recently has also been used partially for business purposes. To qualify for deducting expenses for a home office, the office must be used regularly and exclusively for business purposes.

I will assume that you meet this test. There are then two ways that you can determine the deduction for business use.

Before considering the two methods, I must assume that the office is located within the physical structure of your personal residence. If this is true, then you are considered to have one “dwelling unit” for tax purposes. The dwelling unit has multiple uses.

A dwelling unit is defined as a space that has basic living accommodations such as cooking, toilet and sleeping. So, if you had a detached structure that was used for the office, you would have two dwelling units if both included these basic living accommodations.

I assume you have a single-dwelling unit split into residence and business use. That allows for two methods of computing deductions.

The first is to allocate expenses of the home between the residence and the business portion. Relative square footage is a fair way to do this.

Some of the utilities, mortgage interest and property taxes would be allocated to the business and deducted against business income.

The interest and taxes otherwise reported on schedule A of your return (itemized deductions) would be reduced by what was claimed on the business side. You would also be entitled to deduct depreciation on the business portion of the home. Total business deductions are limited to income from the business.

When you sell the home, the tax law will require you to report taxable gain equal to all prior depreciation claimed on the business portion of the home.

Because depreciation reduces the tax basis of the house, it will also increase the realized gain from the sale.

You may exclude — up to $500,000 — any gain caused by the home appreciation. It is only the portion of the gain caused by reducing the basis that is reported.

There is a second way to compute the office deductions. This is called the “simplified” method.

The simplified method was created by the IRS in Revenue Procedure 2013-13. It is just an IRS-sanctioned alternative way to compute deductions.

With the simplified method, you just deduct $5 per square foot of the office-use space as a business expense. There is a maximum of 300 square feet allowed for this method, so the maximum deduction is $1,500 each year.

With this method, you claim all interest and taxes on schedule A. You are also treated as if you claimed no depreciation.

With no depreciation, you have no gain to report when the property is sold. That is part of the simplified reporting allowed by this method.

If you used the actual expense method, you must report some gain when the house is sold. With the simplified method, there is no gain to report.