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Home Office Expense and Unrecaptured Section 1250 gain

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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.”

Tax Withholding Update: Social Security and Medicare Tax for 2013

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Following the passage of the American Taxpayer Relief Act of 2012, the IRS issued Notice 1036 with respect to withholding tables for the year 2013, which includes the 2013 Percentage Method Tables for Income Tax Withholding.

Under the notice, the IRS requires the employers to implement the 2013 withholding tables as soon as possible, but not later than February 15, 2013. However, the use the 2012 withholding tables is permitted until employers implement the 2013 withholding tables; in such case, the employers should make an adjustment in a subsequent pay period to correct any under-withholding of social security tax by March 31, 2013.

One of the biggest news, of course, is the increase of the employee tax rate for social security to 6.2%. Previously, the employee tax rate for social security was 4.2%. The employer’s tax rate for social security remains unchanged at 6.2%. The social security wage base limit increases to $113,700. The Medicare tax rate is 1.45% each for the employee and employer, unchanged from 2012. There is no wage base limit for Medicare tax.

The second big news is that the withholding taxes will go up with Additional Medicare Tax for certain high-income wage earners. As described in an earlier article, starting January 1, 2013, Additional Hospital Insurance Tax (Additional Medicare Tax) of 0.9% will be imposed on employees who earn wages above certain thresholds. For the withholding purposes, the IRS requests that an additional 0.9% tax is withheld on wages paid to an employee in excess of $200,000 in a calendar year. The employer is required to begin withholding Additional Medicare Tax in the pay period in which he pays wages in excess of $200,000 to an employee and he should continue to withhold the Additional Medicare Tax each pay period until the end of the calendar year.

Note that Additional Medicare Tax is only imposed on the employee; there is no employer share of Additional Medicare Tax.