For homeowners, couple of surprises on tax deductions

March 19, 1995|By New York Times News Service

Homeowners who turn a room into an office may reap tax deductions. And if they convert a bedroom into a rental unit for extra income, they may depreciate the rental property on their taxes.

In both cases, though, claiming those deductions can come back to haunt them when they sell their houses.

For tax purposes, the part of a home claimed as a home office or rented out is considered business property separate from the residence. Any gain or loss on the sale of that property is subject to different rules than a personal residence. For people who sell their homes at a profit, that may mean an unexpected tax bill.

"It's amazing how many people have no idea about this," said Martin M. Shenkman, a lawyer and accountant in New York.

Ordinarily, a capital gain on a home sale can be deferred if the proceeds are plowed into another home. To defer the entire amount, though, both homes must be principal residences, the new home must cost at least as much as the sale price of the old one and the new home must be bought two years before or after the sale. If the new home is outside the United States, though, you have four years.

For older people, there is an extra benefit. People at least 55 can -- once in their lives -- exclude a capital gain of up to $125,000 on the sale of a home.

Neither of these allowances apply, however, to the part of the home used as a Gness property.

"You wind up splitting, theoretically, the property," said Jerome Rebhun, an accountant in New York. "It is as if a house is nine-tenths personal and one-tenth business. Nine-tenths of the capital gains could be rolled over and the rest would be treated as a gain or loss on business property."

Say the house sold for $300,000, and the homeowner's investment in the residence was $100,000. Using the nine-tenths example, the gain on the residence is $180,000, which is eligible for favorable tax treatment, and the gain on the business property $20,000. If the person owes 28 percent in federal capital gains taxes, the bill would be $5,600 on that office.

The easy way to avoid the problem is to convert the space back to home use before selling it. How long before? If homeowners can clearly demonstrate to the Internal Revenue Service that the space was used for a legitimate business purpose and no longer is, perhaps a year will do.

Such moves could call into question the legitimacy of previous tax filings for the home office. Homeowners who stop taking a home office deduction will want to be able to show that the office has been moved or that the business has been dissolved. (Photographs might help.)

Keep in mind that the cost of converting the space back to a residence, including lost income, lost deductions or the additional expense of setting up an outside office, could exceed the potential tax savings.

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