In many cases, people use their homes as offices during the start-up phase of their business to manage their expenses, and at times simply because of the convenience as he/she may have children or dependents that they need to look after While working. Some individuals may also be renting out a portion of their home throughout the year, or during a specific season or certain months as a vacation home to earn extra income or to help with expenses. It is important for these individuals to understand that there are certain tax rules and regulations associated these activities even during the first few years when the business may be running at a loss.
At AG Tax, we sometimes have clients who have not maintained records for their home office expenses because they assumed that since they just started with the business and have made no profit, the expenses serve no purpose. Additionally, taxpayers are often amazed with the tax formalities that they have to comply with when selling homes which were used as offices or rentals.
In this article, we will be discussing the tax consequences of selling a U.S. based home that was also used for business or rental activities, you may read our article on IRS’ Treatment of Business Expenses to know more about deduction of expenses for tax purposes.
Please note that this article is for information purpose only and does not replace professional advice based on a taxpayer’s situation.
General Rule for Income from Sale of Home
In the U.S., an individual is allowed to exclude up to $250,000 ($500,000 in case of married filing joint) of the gain (sale proceeds less cost basis) from the sale of a primary residence from being taxed if the seller/taxpayer owned and occupied the residence in 2 of the 5 preceding years from the date of sale. You must also own and occupy the home as your principal residence for at least two years before you sell it. If you meet the requirements, you can take the U.S. principal residence exclusion no more than once every two years.
Non-U.S. residents should be wary that they may not qualify for this exemption unless they live primarily in their U.S. home throughout a tax year for at least 2 years which could result in being deemed a U.S. resident for tax purposes. Please refer to the following article for additional information (The Closer Connection Exception and Substantial Presence Test).
In Case of a Home that is Partly Used for Business
Business use of a home can include use as a home-based office, a rental or vacation property, a day-care center, or any business-related activity. If the taxpayer uses a portion of his home, i.e. the garage or a room in the house, for carrying out business activities, some of the gain on the home sale may be taxable. If any depreciation was claimed on the business-used portion of the house (after May 1997), it would be recaptured and subject to tax at ordinary tax rates.
However, this does not mean that the exclusion cannot be claimed, if the seller qualifies, i.e. fulfills the use and ownership test, he may still claim the $250,000/$500,000 exclusion, but would be subject to taxes on the business portion of the gain which would need to be reported on Form 4797 – Sale of Business Property.
Example: A single taxpayer owns a 1,000 sq. ft. house and has been living in it for the last 6 years. He uses a room that is 200 sq. ft. (20%) exclusively as his home office to meet clients for business purposes and claims 20% of all his qualifying expenses as business expenses on his tax return, including $15,000 of depreciation expense.
He sells the house for a profit of $200,000, and qualifies to claim the exclusion of $250,000, but since he used a portion of the house for business, he would need to report $15,000 (depreciation amount is recaptured) as ordinary income and the remainder of gain as a capital gain. If instead of a room or part of the home’s living area, it was an attached property, such as a garage or basement apartment with a separate entrance, he would need to allocate 20% of the profit separately for the business portion of the property (in case of a separate structure such as a guesthouse or detached garage, the tax treatment depends upon whether the separate structure itself meets the exclusion qualification requirements).
Taxpayers should note that even if they do not claim depreciation on their return to possibly avoid such a situation, they would still be subject to taxes on the percentage of profit allocable to the business portion, since the IRS assumes that the depreciation has been claimed and the amount of depreciation deduction allowed or allowable will be recaptured as taxable income in the year of the house is sold.
Conclusion
Selling a home which was also used for business or rental purposes can create a complicated tax situation, which is why it is best to be left in the hands of experts. Therefore, if you are considering selling such a property, it is highly recommended to consult a tax professional regarding the tax consequences, and any planning available before initiating the sale.
AG Tax LLP Can Help
If you have any tax-related queries or need assistance with tax planning or filing please contact AG Tax. Our tax professionals are highly-experienced with U.S. and Canadian tax laws and can provide you the right guidance to handle your tax situation.
Aylett Grant Tax LLP is a full service accounting firm with a dedicated team of experts, who are highly-qualified and experienced in handling situations related to U.S., Canadian, and other international tax laws.
We can assist with:
- Canadian Personal and Corporate tax returns
- Cross Border Taxation and Business Planning
- U.S. Personal and Corporate Taxation
- Disclosure of Foreign Assets and other information filings
- Retirement planning
- Estate Planning, Inheritance tax advice
To obtain a quote or to arrange for a consultation to discuss your tax related queries, please contact us at:
- 416-238-5920 (Greater Toronto Area, ON)
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Disclaimer: The information in this publication is accurate as of the time of its publication. AG Tax assumes no responsibility for changes to tax legislation subsequent to the publication of this document. The information provided is for general information purposes only and should not be acted upon without seeking professional advice. If you would like to engage our services, please contact our staff and obtain authorization to send our firm confidential information. A client relationship is not created by the transmission of information. A client relationship is only formed with our firm when a scope and engagement letter signed by the firm and the potential client detailing the terms of engagement is present.
