How to avoid being taxed on the sale of your residence when you have used your residence for office in home and as a rental property!

 By Jeff Brooks CPA, CFP, MBA for JBrooks Wealth Advisors PC, a CPA and Certified Financial Planning firm. jeff@jbrookswa.com

 Although house prices have declined, many people have had many prior years of depreciation tax write-offs by using their principal residence for home office or as a rental property.

 

Example:

John and Mary sell their Condo for net cash of $740,000. The condo cost them $750,000..so they expect to have a loss. However, Mary purchased the house before meeting John and rented the house out for about 10 years. Then after their marriage, John and Mary converted the property to their residence.  Mary ran a small business out of their home.  The small business used 1/3 of the house.  Over the years, Mary has taken tax deductions of $100,000.  What is the problem?  

 

The residence tax basis is not $750,000 but $650,000 and Mary’s CPA tells Mary and John that they have to pay tax on $90,000 “recapture of depreciation” ($740,000 net cash received less $650,000 tax basis, net of depreciation).  

 

 

Did you know that you can avoid taxes on the personal part, office part and rental part of your home?  Yes, you can when you use the correct combination of Code Sections 121 and 1031, along with Revenue Procedure 2005-14.   Specifically,

 

  • You can avoid taxes on the sale of your personal use of your home,
  • Avoid taxes on the sale of the home office part,
  • Avoid taxes on the sale of the rental part,
  • Defer taxes on the depreciation recapture part.

 

To get these tax benefits, you must hire a real-estate exchange intermediary. Cost?  Search the web and you will find fees less than $725!

 

I believe you can use the home-sale exclusion to generate up to $75,000 of tax-free profit on the office part of the sale.

 

In addition, you can take that tax-free profit and add it to the basis of your home office in the replacement residence.

 

 You get tax-free gains turn into additional cost basis in the new residence.

 

By having this large cost basis in the new residence you get tax free depreciation and reduction of profit on the next sale.

 

Principal Residence Tax Avoidance Rule results in no tax on gains up the $250,000 if you are single and $500,000 if you are married. You must comply with a time period to hold the principal residence to get these tax benefits. I call the $250K/$500K as “exclusion”.

 

However, you may be one of my clients who have voiced your concern to me that you will get taxed on part of this “exclusion” because you use part of your residence as a business home office. Recently I discovered that the “exclusion” applies to gains on the business office depreciation that is recaptured…paid back to the government when the house is sold.

 

 What does “recapture” mean?  Recaptured means that now that you sold the business office as part of your residence, the depreciation that you have written off against your income is now taxable and the “excluded” gain under the $250K=Single/$500K married is taxable!  However, reading IRS Code Section 121 tax-free treatment to the gain INSIDE the walls of the residence.

 

If one-fifth of your house is office space, you may apply one-fifth of the $250,000 or $500,000 exclusion to the home-office profits.

 

Revenue Procedure 2005-14 shows you the following:

 

  1. 1.   How to use the 1031 exchange to defer the depreciation recapture tax (which applies to home-office depreciation claimed after May 6, 1978) and
  2. 2.   How to use Section 121 to make the gain on the office part of the home tax-free.

Jeff Brooks, CPA for the firm jeff@jbrookswa.com

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About Jeffrey Brooks

Jeffrey Brooks, CPA, CFP, MBA since 1976 has specialized in helping clients save significant taxes, help businesses increase their cash flow, revenues and profits while increasing their control and satisfaction. Jeff and his accounting firm sincerely cares about the happiness of his clients.

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JBrooks Wealth Advisors, PC.

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Address: 4647 N 32nd Street, Suite B245
Phoenix, Arizona 85018
Phone: 602-292-2009
Email: jeff@jbrookswa.com