Depreciation on a Home Office

The following discussion applies to the home office deduction if you are using the regular method to determine the amount of expenses you may deduct for business use of a home. However, the simplified method is also available if you prefer not to calculate an allocation of depreciation and other expenses.

If you qualify for the home office deduction and you own your home, you can't directly deduct the price you paid for the home, the principal payments you make on the mortgage, or the fair rental value of the home.

Instead, you can recover the cost of the business percentage of the home through depreciation deductions.

Before you can calculate the dollar amount of your depreciation deduction, however, you will need to know the tax basis of your home. To determine your home's tax basis, you start with the lower of:

• the home's fair market value at the time you begin using the home office, or
• the cost of the home (not including the cost of the land), plus the value of any permanent improvements you made before using the home office, and minus any casualty losses you deducted before using it.

In most cases, you'll be using the second of the two items listed above, but if you suspect that your home has declined in value since you bought it, you should have an appraisal done when you start using the home office in order to fix the fair market value at that point in time.

The cost of the home generally includes not only the price you paid to the seller, but also various closing costs and settlement fees such as abstract fees, installation of utility services, legal fees, recording fees, surveys, transfer taxes, title insurance, and any amounts you agree to pay on behalf of the seller such as back taxes or interest, sales commissions, or charges for improvements or repairs. Some fees and costs you may not include are insurance premiums, rent for occupancy before closing, and charges connected with getting a loan such as mortgage insurance, credit reports, appraisal fees, loan assumption fees, and points.

You must reasonably allocate the total costs of the property between the land and the buildings on it to compute your tax basis for depreciation. If your sales contract did not explicitly allocate the price, you should allocate the costs on the basis of the fair market values of the land and buildings at the time of purchase. Your realtor or insurance agent may be able to help you make a reasonable estimate of fair market value.

Your tax basis must be multiplied by the business percentage of your home, to arrive at the amount you can depreciate.

Once you know the tax basis of the depreciable portion of the home, you multiply it by a fraction determined by the IRS, based on the month and year you began using the home for business. Tables showing these fractions are available in IRS Publication 946, How to Depreciate Property. Generally speaking, for real estate that you began using for business on or after May 13, 1993, the depreciation period will be 39 years and in every year but the first and the last, the applicable fraction will be .02564. For the first and last years, the fraction will depend on the month in which business use began or ended.

If you began using your home office before May 13, 1993, continue using the depreciation method that you originally started out with.

Capital improvements. If, after you begin using your home for business, you make a significant, permanent improvement to the property (as opposed to a repair) you will need to depreciate this capital expenditure as well. These are depreciated separately, not added to the basis of the house.

Warning It's important to recognize that when you eventually sell your home, you must reduce the amount of gain you can exclude. You'll be required to pay tax on the amount of capital gain (if any) that's equal to the amount of depreciation you claimed over the years on your home, including depreciation from a home office.

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