In our article, Home Office Deduction Actual Cost Method Part One: Direct and Indirect Costs, we introduce the Actual Cost Method, explain the square footage percentage, and discuss direct and indirect home office costs. This article wraps up the Actual Cost Method with the basics of home office depreciation.
Before we continue – a warning: Depreciation is highly complex. It’s both technical and nuanced, making it difficult to explain in non-technical terms. As we discuss in our article on vehicle depreciation, Congress’s tendency to change depreciation rules compounds this complexity. Fortunately, however, the home office depreciation is relatively straight-forward. The rules have also remained the same, with a few minor exceptions, for well over a decade. Although I still recommend that someone claiming actual home office expenses obtain the assistance of a tax professional, these facts increase my confidence that this article will not become obsolete in a few months.
Home Office Depreciation: If you own your home (are not renting it) and deduct actual home office costs, the portion of the house used as a home office must be depreciated – expensed a little each year for a proscribed number of years. A home office is considered a commercial building. Commercial buildings are depreciated over 39 years using what is called straight-line depreciation. Straight-Line depreciation expenses an equal portion of an asset’s value (in this case, the home office) each year or part of the year the home office qualifies. For a commercial building, the value of the asset is divided by thirty-nine to determine the amount of depreciation claimed for a full year.
As a general rule, the amount of depreciation deducted on a home office is a function of the depreciable value of the home and the percentage occupied by the home office. Depreciable value, also called basis, is the lower of the asset’s cost or fair market value when the property is placed in service. These terms can also be a little confusing. So, here’s a brief overview of each as they apply to a home office:
- Cost: Generally speaking, the cost of an item is what you pay for it. If you purchased the home that contains your home office, its cost is what you paid for the home, plus the price of any significant renovations (discussed below). There are two exceptions to this rule: Inheritance and Gifts. If you inherit the home, your cost is generally the home’s value on the date the previous owner passed away. If the house was a gift (lucky you!) your cost is the previous owner’s cost/basis.
- Fair Market Value: Fair Market Value (FMV) is what the asset is worth when you start to use it for business. Until recently, the fair market value of real property was nearly always higher than the asset’ cost, because, historically, real estate appreciates after purchased. Unfortunately, this assumption died with the housing crisis of the mid-2000s. By 2008 and 2009 the value of nearly any home purchased between 2001 and 2007 was substantially lower than the price paid for it. Today, over ten years later, thousands of properties have fair market values less than their purchase price. When this is the case, the depreciable basis is the home’s Fair Market Value when placed into service.
- Placed in Service: The date an asset is placed in service is the day it starts to be used by the business. For the home office, it’s the day the office meets the definition of a qualified home office.
Land: When calculating depreciation, the value of the property on which the home sits is not included in the basis of the house because land is not depreciable.
Example Home Depreciation: The easiest way to explain home office depreciation is by using an example: Jim paid $250,000 for his home a few years ago. The house is now worth $265,000, so the basis of the home for depreciation is its cost, $250,000, which is lower than the homes fair market value.
Now that Jim knows that he will be using the home’s cost as its basis, he needs to subtract the value of the land from the property. Jim can’t remember what the appraised value of the land was when he purchased it (who can?) so, he needs a way to approximate its value. On his last property tax assessment, the assessed value of the land was 13% of the value of the property as a whole. So, a reasonable estimate of the land’s value is 13% of $250,000 or $32,500. The basis of Jim’s home is $217,500 ($250,000 minus $32,500).
Because Jim uses a percentage of his home as a home office, he must adjust the home’s basis by that percentage. If Jim’s home office is 124 square feet and the total area of his home is 2,200 square feet, the portion of the house that constitutes the home office is 5.6% (124 / 2,200). The result: 5.6% of the home’s $217,500 basis is $12,180. $12,180 is the depreciable basis of the home office.
The portion of the home representing the home office, $12,180, is depreciated over thirty-nine years using the straight-line method. The straight-line method deducts the same amount of depreciation each full year the home office qualifies. $12,180 divided by 39 years is $312.31 per year. Depreciation is reported in part III of Form 8829.
Notes on Home Office Depreciation: Here are a few items to keep in mind regarding home office depreciation.
- Mid-Month Convention: Straight-line depreciation for commercial properties use what is called a mid-month convention. The property is treated as though it is placed in service half-way through the month business use starts. For example, if Jim starts to use his office for business on July 1st, it is not depreciated for six months that year. Instead, it is depreciated for 5.5 months. The same rule (5.5 months) applies if he starts to use the office on July 20th. Jim’s depreciation deduction the first year is the full years’ depreciation of $312.31 divided by 12 months of the year, then multiplied by 5.5 months. So, 312.31 / 12 = 20.03. $20.03 * 5.5 = 143.16.
- Depreciation Reduces Basis: The depreciation claimed on an asset reduces its basis. This remaining basis is used to determine a gain or a loss when an item is sold. This reduced basis is sometimes referred to as book-value, which is an assets original cost (or FMV if lower) minus depreciation. For example, if your beginning basis in a home (including the land) is $150,000 and you have claimed $2,000 in depreciation on the home office, your remaining basis is $148,000 ($150,000 minus $2,000). If you later sell the home for $150,000, you will have a gain of $2,000 ($150,000 minus $148,000).
- Depreciation Can Be Taxable: When the home containing a home office is sold, depreciation claimed on the office can be taxable if the sale generated a profit. Continuing with the example above, selling a $150,000 home on which $2,000 of depreciation has been claimed now has a basis of $148,000. Selling the house for $150,000 will generate a taxable gain of $2,000. Because the $2,000 gain results from depreciation, it is taxed at a 25% rate as what is called recaptured depreciation.
Recaptured depreciation is required even if business-use ceased years before. Depreciation is also recaptured (taxed) when the home qualifies for primary residence exclusion under IRS Code Section 121.
- Depreciation is Not Optional: Depreciating your home office is not a choice. Even if you forego the deduction, the IRS will consider the deduction taken. This depreciation must be recaptured if and when the home’s sale generates a profit.
- Home Basis Includes Major Renovations and Improvements: As mentioned earlier, the depreciable basis of a home includes the cost of significant renovations and improvements. This includes, for example, the cost of constructing an addition or an attached garage to the home as well as a complete renovation of the kitchen. Improvements add value or prolong the life of the asset. They are not repairs or maintenance, which maintain a home’s value and keep its components functional and in good condition.
- Switching to the Simplified Method: If you change to the Simplified Method of deducting the home office in a later year, you do not need to depreciate your office that year. You start depreciating it again if and when you resume using the Actual Cost Method.
Take Away: Depreciating the home office is required when you own your home and use the Actual Cost Method for deducting home office expenses. Depreciation is reasonably complex and must be tracked from year to year, even if business-use stops. It can also create a taxable gain when the home is sold. If you are planning to use the Actual Cost Method for your home office, we highly recommend that you obtain the assistance of a tax professional. The tax-savings will often outweigh the cost. Using a professional will also reduce the likelihood of errors and, therefore, potential problems with the IRS.
Summary and Invite: We hope this article helped you to understand the home office depreciation. If you’d like to learn more about cutting your most significant expense, TAXES, check out our Real Estate Agent Tax Cut Library. The Real Estate Agent Tax Cut Library includes over eight hours of video broken into twenty-nine searchable volumes and covers every possible deduction a Real Estate Agent can take on their tax return. Our Broker Version will help your entire agency cut their taxes! We also invite you to browse our courses.