From the June 2005 issue of Entrepreneur

To deduct, or not to deduct--that has long been the question for those who keep home offices. You are allowed to deduct home-office expenses ranging from repairs to mortgage interest to utilities and depreciation. But if you eventually sell the house, those deductions could come back to haunt you in the form of capital-gains taxes. Instead of getting home-sale profits free and clear (on gains up to $250,000 for singles or $500,000 for couples, assuming that this was your primary residence), you might have to pay the piper for any capital gains attributable to the office.

New guidelines the IRS published in February appear to make things better--if not simpler--for in-home workers. As long as you do a 1031 "like-kind exchange," home-office property can avoid capital gains, too. The trick is that the value of the home office in the new home must be at least as high as the one in the old home. To calculate the value of the old one, figure the square footage of the office as a percentage of the house and multiply that by the sale amount. Do the same for the property you just bought. As long as the new value is equal to or greater than the old one--and as long as the combined capital-gains taxes on the residential and office portions of the house don't exceed the $250,000 or $500,000 limits--you should be able to defer all capital gains.

Eventually, says CPA Tim Kalberg of Perkins & Co. P.C. in Portland, Oregon, you will have to pay capital-gains taxes on the business property. The 1031 exchange defers but does not eliminate the tax on the home office. But there is one loophole: "The only way to purge yourself of that is to die," Kalberg says.

In the meantime, to take advantage of a 1031 exchange on your home office, you'll have to plan ahead. That means having your new property lined up before you sell the old one and moving the proceeds through an intermediary--a subsidiary of your title insurance company, perhaps. If you ever take possession of the money yourself, the exchange is off and you'll owe the capital-gains tax. One more caveat: You can take advantage of the 1031 exchange only once every five years, rather than once every two as with residential property.


Scott Bernard Nelson is deputy business editor at The Oregonian and a freelance writer in Portland, Oregon.