Should You Skip Home Office Depreciation to Avoid Recapture Tax?
- Viktoriya Barsukova, EA, MBA
- Jan 17
- 5 min read
If you are like most taxpayers, the words “recapture tax” describe something you want to avoid.
To avoid recapture of depreciation deductions on the home office, taxpayers do not claim depreciation.
When the taxpayer does not claim depreciation, the tax law imposes the allowed-versus-allowable depreciation rule. For this purpose:
• The depreciation allowed is the amount you claimed on your tax return.
• The depreciation allowable is the amount you should have claimed on your tax return.
The allowed and allowable amounts are supposed to be, and generally are, the same. But when you claim zero depreciation on the home office, you obviously have conflicting amounts.
So what does the IRS do when you have conflicting amounts?
Double Taxation
We will start with the problem, and then we will show you how to escape the problem if you qualify.
Say you claimed zero depreciation (technically called the “allowed amount”—this is the amount you claimed on your tax return). Say the right amount was $5,000 (technically, the “allowable amount”).
In this case, you depreciated your home office by $5,000 but did not claim it on your tax return. This means:
• You increased your taxes by losing out on $5,000 of deductions.
• You could end up paying taxes on the unclaimed depreciation because it reduces the basis in your home by $5,000.
Oops. In the scenario above, you managed to skip $5,000 of depreciation so you could lose $5,000 of deductions and then get taxed on the gain the $5,000 generated because it reduced your basis.
You might think, “Hey, no problem. The Section 121 home-sale exclusion makes the first $250,000 of profit ($500,000 if married) tax-free.”¹ This is true, and if that applies to you, you would skip one tax. But you could still face the recapture tax on the depreciation that you did not claim.
Also, if the office is not inside the walls of the dwelling unit, the $250,000/$500,000 exclusion does not apply to any gain attributable to the home office.²
You can see how double taxation is possible here: First, with no tax deduction for the depreciation, you pay taxes. Second, with an adjustment to your basis for the depreciation you did not claim, you increase the amount of taxable gain and incur tax number two.
Okay, let’s see what you can do to eliminate this problem.
Avoiding the Recapture Tax
To the extent you can attribute your home-sale profits to depreciation of the home, you face the depreciation recapture tax. (On real property, this is known technically as “unrecaptured Section 1250 gain.”)³
Example. You claimed $11,000 of depreciation on your home office and sold that home for a $201,000 profit. Of the $201,000 profit, $11,000 is attributable to your depreciation deductions, and you pay the recapture tax on that $11,000.
But (as explained in the previous section) you never claimed the $5,000 of depreciation. So what happens with that?
Here is a scary thought: Think about your tax records!
Whether you get a favorable, recapture-free tax result depends on your tax records.
In spite of what you may think, the good news is that you have the tax records you need. Yes, you already have them, and in the condition you need them—they are simply your prior years’ tax returns.
In Section 1250(b)(3), the law states in pertinent part: “If the taxpayer can establish by adequate records or other sufficient evidence that the amount allowed [zero, in your case] as a deduction for any period was less than the amount allowable [$5,000], the amount taken into account for such period shall be the amount allowed [zero].”⁴
Technical point. If you are in an audit, you may need to pull out Section 1250(b)(3) to show the IRS examiner the law. No problem. Simply click the link to footnote 4 below and print the PDF reference.
Your tax returns prove the zero depreciation in prior years. How? You claimed the home-office deduction on IRS Form 8829; on the line where you enter depreciation, you left it blank or entered zero. That’s proof.
So your adequate-records tax return works to avoid the recapture taxes. That’s good news. And that’s why you subscribe to this resource.
But what happens to the depreciation when you figure your gain on sale?
Gain on Sale
Tax law doesn’t give you the same break for calculating your gain on sale. You can’t use the allowed amount if it’s less than the allowable amount—you must use the allowable amount.⁵
For you, this means the $5,000 in unclaimed depreciation reduces your basis for purposes of computing gain or loss. And that can trigger taxes in the wrong circumstances.
Putting It All Together
To fully illustrate how the depreciation tax rules on the home-office deduction work, let’s look at two examples.
Example 1. You have a home office inside the walls of your residence. You claimed zero depreciation for the home office (allowed), but you should have claimed $30,000 in depreciation deductions (allowable). Your gain on the sale of this residence is $230,000, $30,000 of which is attributable to depreciation.
Example 2. Assume the same facts as above, but your gain on sale is $325,000 and you are single.
Take Advantage of Depreciation
As you see, your zero-depreciation deduction on your home office helps you avoid the tax whammy for depreciation recapture. But that’s not a good justification for zero depreciation on your home office, for the following reasons:
• By not claiming depreciation, you lost not only the tax deductions but also the time-value-of-money benefits.
• The recapture tax (unrecaptured Section 1250 gain tax) is likely lower—perhaps far lower—than the ordinary tax benefit you receive with the depreciation deduction.
• You can use a Section 1031 exchange to defer the recapture tax when you buy another home that contains a home office that you deduct.⁶
• You get a step-up in basis at the date of death that does away with your recapture problem.
Takeaways
Do not skip depreciation on your home office.
Even if claiming zero depreciation lets you avoid both the recapture tax and the tax on the gain, you still lose economically. You gave up deductions you could have used now, effectively leaving your money with the government instead of putting it to work for you.
In addition, your current tax benefit rate is likely higher today than it will be when any future recapture would apply.
Remember, you can claim depreciation and still completely avoid recapture; there is no recapture at death, and your home’s basis gets stepped up to fair market value.
Finally, don’t look strange to the IRS by consistently reporting a home office without depreciation. Looking strange can increase your odds of IRS scrutiny.
Should You Skip Home Office Depreciation to Avoid Recapture Tax?
Comments