Beware of this home office trap

You can exclude up to $250,000 of gain from your income if you own and occupy a home as your principal residence for at least two of the five years preceding its sale.  A married couple can exclude up to $500,000 if both spouses used the home as their main home during this period.  But if you use your home for both personal and business purposes, such as renting out your basement or using a home office, beware.  When you sell your home, you could be subject to tax on some of the gain.

Example.  In 1998, you started a home-based business that occupied 20% of your home.  You claimed the home office deduction on your 1998, 1999, 2000, and 2001 income tax returns.  In 2002, you sold your home for a $250,000 profit.  Can you exclude the gain?  The answer is not all of it.

You must divide the sale into two pieces because you didn't own and occupy the entire house as your principal home for the required period.  The gain attributed to the personal use portion (80%) will qualify for the gain exclusion because you met the time and use tests.  But the portion of gain attributed to business use (20%) is taxable.

If you sold or plan to sell your home this year, don't wait until tax time to meet with your tax advisor.  It is important to find out the tax outcome now for several reasons.  First, you have time to prepare for any income tax you might owe.  Second, there is still time to make 2002 estimated tax payments to minimize an underpayment penalty.  Finally, if you haven't sold your home yet, there may be tax planning opportunities to consider.