Do you take the home office expense on Schedule C for your small business? While taking the home office expense can help reduce your tax liability, you should be aware of a potential significant downside: unrecaptured Section 1250 gain on depreciation.
This article will explain the basics of unrecaptured Section 1250 gain; it is not intended to convey tax or legal advice. Running a small business can involve many complex tax and legal issues, so you are advised to seek an experienced attorney in these matters. Sherayzen Law Office, PLLC can assist you in all of your tax and legal needs, and help you avoid making costly mistakes.
Section 1250 Property Defined
The IRS defines Section 1250 property to include, “[A]ll real property that is subject to an allowance for depreciation and that is not and never has been section 1245 property. It includes a leasehold of land or section 1250 property subject to an allowance for depreciation.” (Section 1245 property includes a variety of specified types of property, including tangible and intangible personal property).
Treatment of Unrecaptured Section 1250 Gain
Most taxpayers are aware that when single individuals or married couples sell their primary residence, some or all of the gain may be excluded from taxation (the exclusion is $250,000 for single taxpayers and $500,000 for married couples). Gain that exceeds the exclusion amount is then taxed at the favorable capital gains rates.
However, when taxpayers take the home office expense and depreciate their homes, the typical tax rules no longer apply. This is partly because by taking a depreciation expense on a home, a benefit is received in the form of a lower tax liability; thus it only makes sense that the IRS would want a portion of that amount back when a taxpayer finally sells a home (this is referred to as “recapturing” depreciation).
Unlike the general rule for sales or exchanges of property, if depreciable or amortizable property is disposed of at a gain, taxpayers may have to treat all, or part of, the gain (even if otherwise nontaxable) as ordinary income. Whereas the sale or exchange will allow taxpayers to pay at capital gains rates, dispositions involving unrecaptured Section 1250 gain will be taxed at a maximum of 25%, regardless of a taxpayer’s ordinary income bracket. Note that like typical capital gains transactions, dispositions involving unrecaptured Section 1250 gain will still be reported on Schedule D of Form 1040.
Does it Matter if Depreciation Expense Was Not Taken?
A frequent question arises when taxpayers take the home office expense on their Form 1040 Schedule C. Because of the disadvantage of paying tax on unrecaptured Section 1250 gain, taxpayers wonder whether they can simply take the home office expense but not take depreciation expense on their home, thereby avoiding this tax.
Unfortunately, this is not allowed under the Internal Revenue Code. As with rental real estate, taxpayers are imputed to have depreciated their business assets, regardless of whether depreciation was actually taken. As the IRS notes in Publication 946, “You must reduce the basis of property by the depreciation allowed or allowable, whichever is greater. Depreciation allowed is depreciation you actually deducted (from which you received a tax benefit). Depreciation allowable is depreciation you are entitled to deduct. If you do not claim depreciation you are entitled to deduct, you must still reduce the basis of the property by the full amount of depreciation allowable.”