By Alan R. Sumutka and James Volpi
Worth the Effort
Although qualifying for the home office deduction is easier than it used to be, the gray areas of when and how to claim the deduction have only gotten murkier. Fortunately, with the proper planning, the advantages are substantial and well worth the effort of reviewing all possible scenarios.
Transportation deductions, other tax deductions, self-employment taxes, sale of primary residence, and length of residency are factors that impact analysis of the home office deduction as a viable tax planning strategy. The "new" home office deduction and the consequences of the sale of a primary residence are worth a close look.
More self-employed taxpayers may now qualify for the home office deduction as a result of changes enacted in the Taxpayer Relief Act of 1997 (TRA) that became effective in 1999. However, the deduction's advantages can be diminished by the loss of a portion of the $250,000 exclusion ($500,000 if married filing jointly) on the sale of a principal residence, a major tax advantage also enacted by TRA. The issue becomes whether the benefits of the home office tax deduction are likely to exceed the future tax liability upon the sale of the principal residence. The taxpayer's advisor must evaluate the most significant advantages and disadvantages of the deduction, review pertinent tax laws, provide examples, and offer tax planning suggestions.
Advantages of the Home Office Deduction
Advantages arising from qualifying a portion of a principal residence as a home office include the following:
* Home office expense deduction,
* Increased transportation expense deduction,
* Decreased self-employment tax,
* Potential increase in availability and amount of tax benefits correlated to adjusted gross income (AGI), and
* Reduced computer record-keeping requirements.
Home Office Expense Deduction. Under IRC section 280A(c)(1), a taxpayer can deduct--
a portion of the dwelling unit which is exclusively used on a regular basis (A) as the principal place of business for any trade or business of the taxpayer, (B) as a place of business which is used by patients, clients, or customers in meeting or dealing with the taxpayer in the normal course of his trade or business, or (C) in the case of a separate structure which is not attached to the dwelling unit, in connection with the taxpayer's trade or business.
Prior to TRA, the landmark Soliman decision (1993, S CT, 71 AFTR 2d 93-463, 506 US 168, 93-1 USTC) stipulated that the home office generally had to be the focus of revenue-generating activity--not merely a place where the taxpayer conducted the administrative or management activities of the trade or business--in order to constitute a "principal place of business." Thus, the Soliman decision prevented many self-employed individuals from using the home office deduction. TRA opened the deduction to more taxpayers in section 280A(c)(1), by expanding the term "principal place of business" to include "a place of business which is used by the taxpayer for the administrative or management activities of any trade or business of the taxpayer if there is no other fixed location of such trade or business where the taxpayer conducts substantial administrative or management activities of such trade or business."
Self-employed taxpayers that were recently denied the home office deduction under Soliman include a commercial fisherman [LaFavor (TC Memo 1998-366)], a professional musician [Popov (TC Memo 1998-374)], and a physical therapist [Tesar (TC Memo 1997-207)]. Under the new laws, these taxpayers would be more likely to qualify for the deduction.
An "above-the-line deduction" (i.e., a deduction that is not subject to the percentage of AGI limitation) is permitted for an allocable portion of expenses such as real estate taxes; mortgage interest; home casualty losses; and many otherwise nondeductible personal expenses such as depreciation, homeowner's insurance, rent, home repairs, home security systems, utilities, and services such as trash removal and housecleaning (IRS Pub. No. 587, 1998, p. 8). In Hefti (TC Memo 1988-22), the Tax Court even permitted a deduction for an allocable share of lawn care and landscaping expenses where the taxpayer "had clients visiting on a regular basis and the appearance of the residence and the grounds would be of significance" to the taxpayer's business operations.
For taxpayers that do not itemize deductions, the home office deduction allows a deduction for AGI for a portion of real estate taxes, mortgage interest, and home casualty losses in addition to the standard deduction.
Transportation Expense Deduction. The recently issued Rev. Rul. 99-7 (IRB 1999-5, p. 4) clarified the issue of "temporary" work location by noting that "a taxpayer's costs of commuting between the taxpayer's residence and the taxpayer's place of business or employment generally are nondeductible personal expenses." However, the ruling reiterated that "if a taxpayer's residence is the taxpayer's principal place of business within the meaning of section 280A(c)(1)(A), the taxpayer may deduct daily transportation expenses incurred in going between the residence and another work location in the same trade or business, regardless of whether the other work location is regular or temporary and regardless of the distance" (even if the transportation is within the metropolitan area).
Thus, where a taxpayer's qualified office is in a principal residence, these previously nondeductible commuting costs become deductible "above-the-line" transportation expenses. Importantly, these expenses are deductible even if the home office deduction generates a loss on the business activity, because transportation expenses are not covered by section 280A(c)(5) limitations.
Under the mileage method, business miles are deductible at 32.5¢ per mile from January 1, 1999, through March 31, 1999, and 31¢ per mile for the remainder of the year. For 2000, the standard mileage rate returns to 32.5¢ per mile. Under the actual method, deductible costs include lease fees, gas, oil, repairs, tires, insurance, licenses, depreciation, and other actual costs of operation (IRS Pub. No. 463, 1998, p. 15). Under either method, taxpayers can deduct parking fees, tolls (Rev. Proc. 98-62, 1998-52 IRB 25), and the business portion of automobile loan interest and state and local taxes (Rev. Proc. 98-63, 1998-52 IRB 25).
For certain taxpayers, this deduction can be significant and reason alone to claim the home office deduction. Taxpayers whose first and last trip of the day may be lengthy (e.g., salespeople and certain part-time self-employeds) and who incur large auto expenses may find the home office deduction very beneficial.
Decreased Self-employment Tax. Because the home office deduction and transportation expense deduction usually reduce self-employment income, self-employed taxpayers benefit from a reduction in self-employment tax, assessed at a rate of 15.3% of the net earnings from self-employment. Even moonlighting taxpayers that exceed the Social Security wage base of $72,600 from a full-time job obtain a reduction in the 2.9% Medicare portion of self-employment tax.
Tax Benefits Correlated to AGI. Many tax benefits in this area relate to AGI. To the extent that deductions for home office and transportation expenses decrease AGI, the taxpayer may find that other tax benefits become available, or that existing benefits increase. For example, these deductions may reduce a taxpayer's joint AGI below $150,000, resulting in eligibility for a 100% Roth IRA contribution.
In addition, a reduction in AGI may mean an increase in such itemized deductions as medical expenses, casualty and theft losses, and 2% miscellaneous itemized deductions. Other benefits correlated to AGI include the following:
* Exclusions for adoption expenses, education bonds, and Social Security benefits;
* Deductions for rental expenses, traditional IRAs, student loan interest, itemized deductions, and personal exemptions;
* Nondeductible Roth and education IRAs and traditional to Roth IRA conversions;
* Credits for adoption and children, the dependent care credit, the elderly and disabled credit, the earned income credit, the Hope scholarship credit, and the lifetime learning credit; and
* The AMT exemption amount.
In evaluating the costs and benefits of the home office deduction, the preceding tax benefits should be considered on a case-by-case basis.
Reduced Computer Record-Keeping Requirements. Under IRC section 280F, computers and peripheral equipment used by a self-employed taxpayer are subject to the listed property requirements. However, such equipment used in a home office is not considered listed property, which eliminates the need to comply with these laws. Although relaxing these requirements does not readily translate into dollar terms, it does provide a nonquantifiable benefit to taxpayers.
Disadvantages of the Home Office Deduction
Several disadvantages arise from qualifying a principal residence as a home office:
* A potential loss of part of the exclusion on the sale of a principal residence;
* A decrease in deductions for self-employment tax and self-employed retirement plan contributions; and
* A perceived increase in audit risk.
Loss of Exclusion on the Sale of a Principal Residence. IRC section 121 provides for a $250,000 exclusion ($500,000 for certain taxpayers filing married jointly) on gain from the sale or exchange of a principal residence if "during the five-year period ending on the date of the sale or exchange, such property has been owned and used by the taxpayer as the taxpayer's principal residence for periods aggregating two years or more" and the taxpayer did not use the exclusion "during the two-year period ending on the date of such sale or exchange." Taxpayers that fail to satisfy the above requirements may be entitled to a partial exclusion if the sale is due to a "change in place of employment, health, or ... unforeseen circumstances" (yet to be defined by IRS regulations).
However, a taxpayer operating a home office at the time of the sale of a residence cannot justify the entire property having been used as a principal residence for the two-year period. Thus, the taxpayer must allocate the residence between personal use and business use. The personal use portion is a capital asset, eligible for the above exclusion. The business use portion is an IRC section 1231 asset, depreciated as MACRS nonresidential real property over a straight-line period of 39 years. Per IRC section 121(d)(6), gain attributable to depreciation taken after May 6, 1997, is upon sale unrecaptured IRC section 1250 gain, taxed at a maximum rate of 25%, and any excess gain is section 1231 gain. If the sale of the residence results in a loss, the personal use portion is not deductible. However, the business use portion is deductible as an IRC section 1231 loss.
A taxpayer who does not claim a home office deduction for at least two years prior to the sale of the principal residence can justify that the entire property has been used as the taxpayer's principal residence for periods aggregating two years or more. Accordingly, upon sale, no allocation of the residence between personal and business use is required. However, gain attributable to depreciation taken after May 6, 1997, is unrecaptured section 1250 gain, taxed at a maximum rate of 25%, and any excess gain is capital gain, eligible for the above exclusion. If the sale of the residence results in a loss, none of the loss is deductible.
Decreased Deductions for Self-employment Tax and Self-employed Retirement Plan Contributions. As noted above, to the extent that the home office and transportation expense deductions decrease self-employment income, they reduce self-employment tax and the related deduction for one-half of self-employment tax. Although the tax reduction will more than offset the benefit of the tax deduction, the taxpayer will want to consider both implications in evaluating this issue.
Similarly, if the taxpayer has a self-employed retirement plan, such as an SEP, SIMPLE, or Keogh, reducing self-employment income reduces the contribution (and deduction) related to these plans.
Perceived Increase in Audit Risk. Many financial commentators suggest that individuals claiming the home office deduction are more susceptible to an audit. Although no statistics exist to back up such a claim, taxpayers and their advisors need to consider this issue. Regardless, under the U.S. self-assessing system, individuals that qualify for the deduction and benefit from it should use it. With adequate records, the deduction should be sustained upon audit.
Evaluating the Trade-offs: Examples and Planning Recommendations
Because the benefits of claiming a home office deduction vary by taxpayer, each situation should be evaluated on a case-by-case basis. The following examples illustrate how to decide whether to claim the home office deduction.
Case Study. Jane, a 48-year-old married, self-employed architect is in the 31% Federal tax bracket. She uses one of the 10 rooms in her residence as her office but was ineligible for the home office deduction prior to 1999 because of Soliman. In 1999, Jane qualifies for the deduction because she uses her office to conduct administrative and management activities. At December 31, 1998, she has a tax basis in the residence of $264,000, of which $66,000 is allocated to land (25%) and $198,000 is allocated to building (75%). Therefore, $19,800 of the property is eligible for depreciation (10% allocated to home office). Jane estimates her annual indirect expenses for the home office (mortgage interest, real estate taxes, utilities, insurance) at $1,755 and annual depreciation (ignoring the mid-month convention in the first year) at $508. Because she can now deduct her first and last business trips home, she expects to deduct about $653 annually in transportation expenses using the mileage method. As of January 1, 1999, Jane's residence was valued at $300,000, and she anticipates 2% annual appreciation. She plans to retire in 14 years (at age 62 in 2012) and sell the house, paying a 6% sales commission and $2,000 in closing costs.
Question: Jane is eligible for $2,916 ($1,755 + $508 + $653) in additional deductions annually for 14 years from her home office. Should she claim the deductions, risk the loss of the exclusion on the sale of her residence, and be required to pay tax on the gain on the sale of the business portion of the residence?
Answer: As illustrated in Exhibit 1, Jane's annual tax savings amount to $1,252, or $17,528 over 14 years (in current dollars). The present value of these savings, discounted at 6% annually, is $12,336. As shown in Exhibit 2, Jane's only tax costs occur 14 years later, as a result of the sale of the house, and equal $3,900. The present value of these tax costs, discounted at 6%, is $1,725 ($3,900 x .44230). Thus, the present value of Jane's net tax savings over 14 years, discounted at 6%, is $10,611 ($12,336 $1725).
Obviously, despite the loss of some of the exclusion, Jane will benefit from claiming a home office deduction. Also, the actual savings might be even greater, because the calculations in the example do not include the likely savings from state income taxes, retirement plan contributions, added deductions from a lower AGI, and a less than 2% property appreciation rate (as explained below).
The above scenario highlights several tax planning opportunities.
Probability of Incurring a Loss on the Sale of the Principal Residence. If the taxpayer expects to incur a loss, no tax costs occur upon the sale of the property (i.e., no unrecaptured IRC section 1250 gain on the depreciation and no IRC section 1231 gain on the portion of the residence allocated to the home office). In fact, a loss on the sale of the principal residence may result in a deductible IRC section 1231 loss generated from the portion of the home allocated to the home office. As such, claiming the home office deduction now poses almost no future risk.
Although recent times have seen increasing property values due to high housing demand and low mortgage rates, some commentators predict decreasing property values due to the retirement and relocation of baby boomers.
Gain on the Sale of the Residence Is Probable; Cease Claiming the Deduction Two Years Before Sale of the Residence. If Jane stops claiming the home office deduction at the end of the year 2012 and continues to live in the residence before selling it in 2015 (at age 65), she has used the entire property as her principal residence for at least two years before the date of sale and must pay tax on only the unrecaptured IRC section 1250 gain. Thus, the tax upon the sale of Jane's residence in 2015 drops to only $1,778 ($7,112 x 25%) in current dollars, or $700 when discounted at 6% over 16 years ($1,778 x .39365).
This strategy is a powerful planning tool because it is easy to execute (e.g., no longer use the home office exclusively for business) and it eliminates the major uncertainty in claiming the home office deduction (the amount of appreciation in a taxpayer's principal residence that must be allocated to the home office and subjected to tax as section 1231 gain). Only the unrecaptured section 1250 gain remains subject to taxation at a 25% rate, an amount represented by the very predictable straight-line depreciation.
The Taxpayer's Self-employment Activities Will Generate a Loss. If the activities are unlikely to be profitable, claiming a home office deduction may not be profitable, either. Because the home office deduction is not deductible if it creates a loss [per IRC section 280A(c)(5)], claiming a home office may generate no significant tax benefits. Also, adversely, the portion of the residence allocated to the home office may generate taxable section 1231 gain upon sale. However, these negative consequences may be tempered by the transportation deduction, which is not governed by the loss limitation.
Select the Area of the Home Office. Jane derives most of her benefits from the home office deduction ($2,263), not the transportation deduction ($653). Therefore, her best interests are served by using the method (e.g., square footage, number of rooms, or another reasonable method) that affords her the maximum space allocable to the home office. Despite a reasonable (10%) allocation, the example shows--
* depreciation deductions are unlikely to be large (due to the 39-year straight-line recovery period), so tax on unrecaptured IRC section 1250 gain should be small;
* the greater the projected time until the sale of the residence, the lesser the adverse tax consequences in present value terms; and
* tax on IRC section 1231 gain resulting from the business use of a portion of the residence can usually be eliminated by proper planning.
By contrast, in another example, Bill, a self-employed salesman, lives in a condominium and will relocate shortly. He will have driven 59,450 miles in 1999. If he claims no home office, as he is eligible to do, the business use percentage of his vehicle is 86%. If he claims a home office deduction, the business use percentage jumps to 99%, due to the deductibility of the first and last business trips for each day. The result is an added annual transportation deduction of $2,387, which is likely to continue into the future.
Bill anticipates a nominal indirect home office expense deduction from the 4% of space allocated to his home office in his condominium. Because the condominium cost $85,500, the depreciable basis is $3,420, or about $88 annually in depreciation deductions over its 39-year recovery period.
In this scenario, selecting a small (4%) office space appears to be prudent because--
* depreciation deduction and indirect expenses are minimal (thus, a small home office deduction, small unrecaptured section 1250 gain, and small capital gain);
* Bill is likely to sell the residence in the near future, paying some minimal tax in the near-term that offsets the short-term tax benefits; and
* the transportation expense deduction clearly generates the greatest tax benefit; thus, a valid home office of any size guarantees a deduction. Furthermore, if Bill's self-employment activities generate a loss, the transportation expenses would be deductible because they are not governed by the home office deduction, even though the home office expenses would not be deductible.
Possibility of Unfavorable Tax Consequences. With proper planning, a taxpayer can eliminate most of the home office deduction's negative tax consequences. However, the deduction may not be beneficial if any of the following conditions occur:
* Little increase in the transportation deduction because of short first and last business trips;
* A large home office space that generates a small home office deduction because of small expenses (e.g., a low basis, generating small depreciation deduction and low maintenance costs);
* The home office deduction may not be deductible due to unprofitable operations;
* The taxpayer's residence is appreciating rapidly and a gain upon sale is likely; and
* The taxpayer will or must sell the property within two years, eliminating the possibility of avoiding the IRC section 1231 gain by ceasing to claim the home office deduction, thus losing the favorable long-term tax deferral of a distant sale.
Seize Opportunities When You See Them
In most instances, the "new" home office deduction trades probable current tax deductions for possible future tax liabilities. In most cases, proper planning makes the deduction beneficial to eligible taxpayers. *
Alan R. Sumutka and James Volpi are associate professors of accounting at Rider University in Lawrenceville, N.J.
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