Sure it offers a fat break for people who qualify. But beware: If you sold your home last year, or will sell sometime soon, this may be a costly mistake.
IT PRETTY MUCH goes without saying that most self-employed folks should deduct their home-office expenses (assuming they qualify). After all, it's one of the great perks of working from home. But it can be a costly mistake if you sold your home last year or earlier this year, or if you expect to sell in the near future. Why? Because you could lose part of that extremely valuable tax exclusion on gains from a home sale, a generous break that exempts you from owing any tax on gains of up to $250,000 (if single) or $500,000 (if married).
The problem? To qualify for the home-sale exclusion, you need to meet a few basic requirements. Most important, you generally must have used the home as your principal residence for at least two of the past five years prior to the sale date. And unfortunately, taking a tax-year 2000 home-office deduction could prevent you from passing this key test.
Say you used 20% of your townhouse as a deductible home office from 1997 through the tail end of 2000. You then sold the home in December 2000. (Before 1997 you didn't take the home-office deduction.) If you claim a home-office write-off on your 2000 return, you'll fail the two-out-of-five-years test for the office part of your home. Why? Because that space was used for business purposes rather than as your personal residence for four years during the critical five-year period. And this means you'll owe income tax on 20% of your gain. You'll also owe taxes on the amount of gain equal to the home-office depreciation claimed on your 1997-2000 returns. If you made a big profit on your home sale, this taxable figure could be quite hefty.
What to do? Consider foregoing the home-office deduction when you file your 2000 taxes. Now the $250,000/$500,000 gain exclusion is available to shelter the profit on your entire home, including the office part. That's because you now pass the two-out-of-five-years test for the entire residence, since you had no business use before 1997 and claim none in 2000.
There is one small caveat. Even with this move, you'll still owe taxes on any home-office depreciation for the period from May 7, 1997, to Dec. 31, 1999. (May 7, 1997, was the effective date for a tax-law change that included this rule.) But, as you probably know, for most people depreciation is just a small part of their total home-office deduction. So don't let this deter you.
Also, keep in mind, this wise tax move will also apply on future tax returns if you plan to sell your home in the next five years. So consider yourself duly warned.