The tax traps of working at home

Two potential problems

But the devil is in the details. Let's look at two common but important catches.

First: Let's say the Internal Revenue Service questions the computer in your office. An agent may ask if you use the computer 95% for business and 5% for personal purposes, or whether you use the computer 50% for business and 50% personal.

The question is a trap! Both answers are wrong. Remember: You must use the office exclusively for business. So, any answer of less than 100% for business completely disallows all your home-office deductions! (Don't make faces at me. I only report the law; I don't draft it.)

Second: If you're planning to sell your home in the near future, taking a home office deduction can be a tax trap!

Here's why. Under current law, if you sell a home that was your principal residence for two of the last five years, you can exclude from income as much as $500,000 in gain on a joint return ($250,000 on other returns).

You don't have to roll over the dollars, nor do you have to be age 55 or older to qualify for the exclusion (as were the alternative qualifications under prior law). All you need to qualify is to have the house as your principal residence for two of the last five years.

But if you've been taking home office deductions, the percentage of your home that you used as an office doesn't qualify for "principal residence" status.

So, if you took 10% of your home as an office deduction, then 10% of your profit didn't qualify for the exclusion. That means that if you actually had a $500,000 gain, $50,000 of that gain became potentially taxable!

But the IRS changed the rules and gave away the farm. Now you're subject to tax only on gain to the extent of depreciation since May 7, 1997.

That depreciation is going to be recaptured to the extent of any profit realized on the sale. And that amount is taxed at a rate a high as 25%. But hopefully, you've been deducting that depreciation at a rate of 28% or better, and you have both the spread and the time value of the money to your net benefit.

But even traps may contain some good news. Current law disallows any loss deduction for selling a home for less than what it cost you. But if you had a home office in that house, to the extent the property was used for business, you have a fully allowable business-loss deduction. You can't accumulate wealth by taking losses, but at least the deduction helps reduce some of the pain.

Updated July 6, 2009

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