Part of Home Used as Deductible Home Office

The first thing to know is you cannot exclude the part of your gain that's attributable to depreciation writeoffs claimed for periods after May 6, 1997. That amount of gain is considered "unrecaptured Section 1250 gain" and is therefore taxed at a maximum rate of 25 percent. You should have no complaints about this, because your depreciation deductions reduced your "ordinary income" in earlier years. So you saved taxes at your regular rate (possibly over 50% counting self-employment taxes).

Example 1: Let's say you are a single taxpayer who used part of your home as a deductible home office in 1997 and 1998. In 1999 and 2000, you did not claim any home office writeoffs. Assume your depreciation deductions for periods after May 6, 1997 totaled $2,100. You must reduce the tax basis of your home by that amount (ditto for any earlier depreciation deductions claimed against your house). You now have a contract to sell your home on January 5, 2001. Your total gain will be $252,100. Of that, $2,100 is attributable to your post-May 6, 1997 depreciation deductions. You must include the $2,100 gain on your 2001 tax return. You can exclude (delete from your 1040) the remaining $250,000 of gain. This is because you qualify for the full $250,000 gain exclusion allowable to single taxpayers. The reason: you owned the home for at least two years during the five-year period ending on the sale date, and you used the entire property as your personal residence for at least two years during the five-year period. That's all the law requires.

Example 2: Same as Example 1, except you are married and the gain from selling your home will be $502,100. Your spouse has also lived in the home for at least two years during the five-year period ending on the sale date. As in Example 1, you will be taxed on the $2,100 gain attributable to your post-May 6, 1997 home office depreciation deductions. You can exclude the remaining $500,000, because you qualify for the $500,000 exclusion available to married taxpayers who file jointly. Note that to get the $500,000 tax break, both spouses must have used the home as their primary residence for at least two years during the five-year period ending on the sale date.

Example 3: Now assume you used part of your home as a deductible home office during 1999 and 2000 but used the space as part of your residence during 1996, 1997, and 1998. Your home sale closing date is January 5, 2001. As in the earlier examples, you must still pay tax on depreciation deductions attributable to post-May 6, 1997 periods. But you are able to shelter your remaining gain with the full exclusion amount (either $250,000 or $500,000). Why? Because you used all of the home as your principal residence for at least two years during the five-year period ending on the sale date. That residential use can occur at any time during that five-year time frame. The residential use need not be during back-to-back periods.

Reduced Gain Exclusion for Home Office

As we explained in the last Tax Byte, the "reduced" gain exclusion rule rescues many taxpayers who fail to meet the two-year residential use requirement. Under this rule, you are entitled to a proportion of the full $250,000/$500,000 gain exclusion, based on your actual residential use as a proportion of two years. But to qualify for the reduced gain exclusion, your home sale must be necessitated by: (1) a change in place of employment (yours or your spouse's if you file jointly) or (2) health reasons (yours or your spouse's if you file jointly).

We'll explain a little later how the reduced gain exclusion privilege might save your bacon in the context of a deductible home office. But let's address another more fundamental question first.

What constitutes a change in place of employment? The new proposed regulations are silent on the subject. Nevertheless, we believe you can clearly take advantage of the reduced gain exclusion rule if you (or your spouse if you file jointly) change job locations and can claim a moving deduction on your return.

To deduct moving expenses, the distance between your new job location (or your spouse's) and your old home (the one you are selling) must be at least 50 miles more than the distance between your old home and your old job.

Since the proposed regulations are non-specific, you might still be eligible for the reduced gain exclusion even if your relocation doesn't allow a moving expense deduction. But that requires a greater leap of faith.

Now let's say you are self-employed and used your home office as your principal place of business (job location). You qualify for a moving expense writeoff as long as the new home is at least 50 miles away from the old one and the new home office is also your new principal place of business (in other words, your new job location).

You also qualify for a moving expense deduction if your new principal place of business is outside your new home but is at least 50 miles away from your old home (your old job location).

Finally, you also qualify for a moving expense deduction if both your new and old principal places of business are outside the home, as long as the distance between your old home and your new place of business is at least 50 miles farther than the distance between your old home and your old place of business.

Once again, you might still be eligible for the reduced gain exclusion even if your relocation doesn't qualify for a self-employed moving expense deduction. But you are on less solid ground.

Of course, the same considerations apply if you file jointly and your spouse is the one who is self-employed.

Bottom line: There are lots of ways to argue that you are eligible for the reduced gain exclusion privilege. Now let's see why it matters.

Example 4: Assume you are married and have owned your home for at least five years before the sale. For the last four years, you used what was formerly a large den and connected bathroom regularly and exclusively as the principal place of business for your Schedule C sales business. Based on square footage, you treated 20 percent of the house as a deductible office and claimed the resulting writeoffs, including $6,000 of depreciation. Say $3,500 of the depreciation is for periods after May 6, 1997. Your home's basis before depreciation was $300,000.

You are now moving into a new home, which will contain your new home office (your new principal place of business). The new home is at least 50 miles from the old one.

You are selling the old home for $750,000. Your total gain is therefore $456,000 ($750,000 - $294,000 basis). The gain on the residence part of the home is $360,000 [.80 x ($750,000 - $300,000)]. You can more than shelter the $360,000 gain with the $400,000 gain exclusion allocable to the residence part of your house (.80 x $500,000 = $400,000). So far, so good.

The gain on the office part of your home is $96,000 [$6,000 + .20 x ($750,000 - $300,000)]. You must include an amount of gain equal to the $3,500 of post-May 6, 1997 depreciation on your tax return for the year of sale. The question is: what happens to the remaining $92,500 of gain from the home office? Because you pass the 50-mile test for a moving deduction, you should be able to exclude $50,000 under the reduce gain exclusion rule (.20 x $500,000 x .50 = $50,000), since you used the office space as part of your residence for one year during the five-year period. Ditto if you or your spouse had to move for health reasons.

Based on this interpretation, you report only $46,000 of gain on your 1040 ($3,500 + $92,500 - $50,000). You exclude the remaining $410,000 of gain ($360,000 on the residence part of the house and $50,000 on the office part). Good deal!

Do the new proposed regulations tell you to follow the procedure in Example 4? Nope. The regulations are silent on how to handle this situation. For now, it's up to taxpayers to figure out how the reduced gain exclusion rule works with a deductible home office in the equation. But the method explained in Example 4 is certainly a reasonable approach. Example 5 explains another approach that more aggressive taxpayers might want to consider.

Example 5: Same as Example 4, except you want to be more aggressive in calculating the reduced gain exclusion for the office part of your home. This time we assume you "use up" only $360,000 of your $500,000 gain exclusion on the non-office part of your home. This is just enough to shelter your $360,000 gain on that part of the house. That leaves $140,000 of gain exclusion. We then assume you can use half of that amount, or $70,000, under the reduced gain exclusion rule to shelter the gain on the office part of your home. Under this more aggressive interpretation, your gain on the office is only $26,000 ($3,500 + 92,500 - $70,000). You exclude the remaining gain of $430,000 ($360,000 on the residence part of the house and $70,000 on the office part). Better deal! Is this OK with the IRS? Who knows? Nothing in the proposed regulations says you can't follow this approach. In fact, it may make more sense technically than the more conservative alternative used in Example 4.

Strategy: In both Examples 4 and 5, you would have been better off with two year's worth of residential use of the office part of the home. Then you could have excluded the entire gain on your home sale, except the part attributable to post-May 6, 1997 depreciation (as in Examples 1, 2, and 3). Similarly, you would have been taxed on the entire gain on the office part of your home in Examples 4 and 5 if you had zero years of residential use of that space during the five years before the sale. The message: when you know you are going to sell your home for a big gain in the relatively near future, foregoing a home office deduction on the next 1040 you file could be a really smart move. You can obliterate any chance for a home office deduction simply by using the space for personal pursuits at any time during the tax year in question. In most cases, this means giving up a few thousand in deductions. Small price to pay if you can then shelter tens of thousands (or more) of home sale gain.

Example 6: Same as Example 4, except this time the gain on the non-office part of your home is $500,000 (or more). In this situation, you would prefer to use the entire gain exclusion to shelter the profit on the non-office part. That way you don't lose any of the $500,000 exclusion under the reduced gain exclusion rule for the office part of the house. So can you use the entire $500,000 exclusion just to shelter the gain on the non-office part? We don't see why not. The basic rule says you can exclude up to $500,000 of gain from selling a property used as the principal residence for at least two years out of the five-year period ending on the sale date. The non-office part of the home meets this requirement. Case closed until further notice from the IRS.

Marriage of Two Homeowners

Example 7: You marry and decide to live in your home until you find a new residence that you both like. Your new wife can sell her house and exclude up to $250,000 of gain, as long as she owned and used that property as her main residence for at least two years during the five-year period ending on the sale date. If you meet the same rule, you too can exclude up to $250,000 when you sell your house, even if your sale occurs less than two years after that of your wife. It doesn't matter if you file jointly or separately after the marriage.

What if you file jointly and one spouse has a gain under $250,000 while the other spouse has a gain over $250,000? Unfortunately, the spouse with the larger gain cannot take advantage of the other spouse's "unused" gain exclusion. Sorry about that. However, see the next example for a strategy you may be able to use here.

Example 8: Say your new husband has a $200,000 gain on his home, while you have a $450,000 gain on yours. Sell your husband's home first. He can shelter the entire gain with his $250,000 exclusion. After the sale he moves into your home and lives there with you for at least two years. At that point, you can sell your home, file a joint return, and exclude up to $500,000 of gain. Why? Because: (1) you both lived in the home for at least two years during the five-year period ending on the sale date, (2) at least two years have passed since your husband took advantage of the gain exclusion break, and (3) you file jointly for the year of sale. Sweet!

Plan Ahead If Divorcing

Say you are still married at the end of the year you sell your home. You can claim the full $500,000 gain exclusion by filing jointly for that year. With a joint return, it doesn't matter if the home is owned 50/50, or 100/0, or in any other proportion. But at least one spouse must have owned the home for at least two years during the five-year period ending on the sale date.

Both spouses must have used the home as the principal residence for at least two years during the five-year period.

If you each owned part of the home and file separate returns for the year of sale, you are each entitled to a $250,000 exclusion, assuming you each: (1) owned your part for at least two years during the five-year period ending on the sale date and (2) used the home as your principal residence for at least two years during the five year period. The sale can happen before the year you are divorced or later. The tax results will be the same.

The preceding rules are pretty reasonable, because they generally allow a soon-to-be-split couple to convert their home equity into cash and go their separate ways without owing Uncle Sam.

However in many cases, a divorcing couple's home is sold years after the divorce. What happens then?

Say one ex-spouse winds up owning the home -- which was formerly wholly owned by the other party -- pursuant to the divorce property settlement. In this situation, the second owner is allowed to count the former owner's ownership period if necessary to meet the two-out-of-five-years ownership test. This permits the second owner to qualify for the $250,000 gain exclusion if the property is sold shortly after the divorce. (The second owner must also use the home as his or her principal residence for at least two years during the five-year period ending on the sale date.)

In many cases, the ex-spouses will continue to co-own the residence after they split. However, only one party will continue to live there. After three years of this, the nonresident ex-spouse will fail to meet the two-out-of-five-years use test. Then when the home is finally sold, his or her share of the gain will be taxed in full. Ouch!

Strategy: Here's how to avoid the ouch. Specify in the divorce papers that one ex-spouse is allowed to continue to use the home owned (or partly owned) by the other party, for example until the children are grown or for a designated number of years. This allows the nonresident ex to receive "credit" for the other party's continued use of the residence.

Example 9: After a divorce, you retain 50-percent ownership of the home you and your ex-wife lived in. The home is worth way more than you paid for it. Luckily, you visit this site and include a provision in your divorce papers that specifically grants your ex the right to continue living in the home, at least until the youngest child graduates from high school. At that point, the property is to be sold with the proceeds split 50/50. Alternatively, your ex can buy your 50-percent interest for fair market value. Say the home is sold six years after you move out for a total gain of $500,000. No problem. You can shelter your $250,000 share of the gain, because you get credit for your ex's continued use of the property as her principal residence. So you meet the two-out-of-five-years ownership and use requirements and qualify for the full $250,000 gain exclusion. So does your ex. So she can exclude her share of the gain too. What happens if you fail to include the magic language in your divorce papers? You are taxed on your entire $250,000 gain. Don't blame us!

Death of a Spouse

You can file a joint return with a deceased spouse for the year he or she dies. (In later years, you must file as a single taxpayer unless you remarry.) So if you sell your home in the year your spouse dies and file jointly with the deceased, you qualify for the $500,000 gain exclusion -- as long as you can meet the other eligibility rules.

If you sell in a later year, you can only claim the $250,000 gain exclusion, unless you remarry and your new spouse uses your home as his primary residence for at least two years.

Remember that in either case, you are also entitled to a basis increase if you inherit your deceased spouse's share of the home. The tax basis of your spouse's share (which you now own) is increased to its fair market value on the date of death (or the date six months after death if the "alternate valuation date" is used for estate tax purposes). That basis increase combined with your gain exclusion privilege should substantially diminish or completely wipe out any federal capital gains tax when you sell the home.

If your home was titled as community property, you get to increase the tax basis of the entire home to fair market value (the half you already owned plus the half inherited from your deceased spouse). So if you sell the home within a reasonable period after your spouse's death, you will owe zilch to the IRS, unless it appreciates dramatically during that short time.

Effective Date for New Rules

Here's the catch. The proposed rules are not technically effective until issued in the form of final tax regulations. The new final regulations will then apply to home sales occurring on or after the date of issuance.

As a practical matter, the current proposed regulations are all we have to go by until those final regulations come out. So you can rely on the material in this article until then. By the way, we don't expect the final regulations to be significantly different from what you read here.