Warning -- It Might Cost You Money!
Both Royce E. Chaffin email@example.com and George (Steve) Busby firstname.lastname@example.org are Certified Public Accountants and Associate Professors of Accounting at the State University of West Georgia.
The passage of the Taxpayers Relief Act of 1997 eased the rules somewhat for deducting office-in-the-home expenses so that more taxpayers will be able to qualify for the deduction beginning in 1999. Because there are a growing number of taxpayers who manage businesses from their homes, it is reasonable to expect that many will consider taking the deduction. However, while the new law makes it easier for taxpayers to qualify for the deduction, not everyone will actually benefit by taking it. Individuals who plan to sell their residence within the next few years at a profit should give careful thought to the idea before taking the deduction -- even if they are otherwise qualified. Those who have significant self-employment pension plan contributions or with other wages which will reduce the self-employment tax may find they have a negative cash flow from the deduction when the time value of money is considered. Current savings from home office deductions may be more than offset by additional taxes in the future if the property is sold. At the end of this article there is a spreadsheet template that you can download that can be used to evaluate your individual situation.
RULES FOR QUALIFYING FOR THE HOME OFFICE DEDUCTION
Unless it is in a separate structure, the office in the home must be used exclusively for business and on a regular basis for these purposes. An employee can only qualify if the business use is for the convenience of the employer.(1) For tax years beginning in 1999 the term "principal place of business" will include a place of business that meets the following two-part test:(2)
(1) the place of business must be used by the taxpayer for the administrative or management activities of any trade or business of the taxpayer; and
(2) there must be no other fixed location of that trade or business where the taxpayer conducts substantial administrative or management activities of that trade or business.
The new law is flexible enough to allow for some administrative or management activities at a place other than the home office as long as it is not a substantial amount.
HOME OFFICE EXPENSES
The expenses that may be deducted are specified, and may not exceed the income from the business. The first sequence of expenses is those that would be deductible at any rate; i.e., home mortgage interest, property tax on the home, and casualty losses from the home. These are deducted from the income of the business before any other expenses can be taken. Next, direct expenses (those which benefit only the business portion of the home) plus a prorata share of the homeowners insurance, home repairs, utilities, and other expenses, including maids and other household employees is taken - subject to business income limitations.
In the final category of deductible expenses is depreciation, again, subject to having income left after the other two categories. It should be kept in mind that basis is adjusted by depreciation which is "allowed or allowable" so, even if the home office deduction is limited by income (the deduction will carryover to future periods.), the basis of the business portion of the house will continue to decline as the accumulated depreciation account increases.(3)
SPECIAL RULES FOR TRANSPORTATION EXPENSES
Transportation expense may be a factor in taking the home office deduction if the taxpayer travels a great deal from his/her home to the work sites. In general, as the Internal Revenue Service points out, daily transportation expenses incurred in going between a taxpayer's residence and work location are nondeductible commuting expenses. However, Revenue Ruling 94-47 specifies three sets of circumstances in which those expenses are deductible. One of these is if a taxpayer's residence is his or her principal place of business for purposes of section 280A(c)(1)(A). In this case 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.
(NOTE: This IRS position is in conflict with the Tax Court in at least one instance. The Walker case(4) permitted a taxpayer to deduct daily transportation expenses incurred in going between his residence and numerous temporary work sites. The court allowed a deduction for these expenses based on its interpretation of Revenue Ruling 90-23, notwithstanding that the taxpayer's recurring work at the residence, while sufficient in the court's view to make that location a regular place of business, was not sufficient to qualify the residence as a principal place of business within the meaning of section 280A(c)(1)(A).)
One important reason for being cautious about the home office deduction is that the tax law governing the sale of a residence has changed substantially in the last couple of years, making it much easier to exclude gains on the sale of personal residences. You should make sure that the benefits derived from claiming the home office deduction are not nullified by additional taxes relating to the future sale of the residence.
The problem arises from the fact that once a portion of the residence is set aside as a home office; that portion of the residence no longer qualifies as a personal residence but is considered business property. If the residence is later sold the proceeds must be allocated equitably to the residence (personal portion) and to the home office (business portion). The gain exclusion rules for a residence ($250,000- single, $500,000 married filing jointly) would not apply to the business portion of the residence so the taxpayer could wind up with a tax liability that would more than offset the tax benefits associated with claiming the home office deduction.
(Note: The former strategy of not taking home office expenses in the year the residence is sold in order to convert back to personal will not solve the problem now. Gain will still be recognized to the extent of any depreciation allowed or allowable after May 6, 1997.(5) However, if the office space is made to be non-qualifying (moving a personal T.V. in, for instance) for the last two years before sale, probably only the amount of depreciation after May 6, 1997 would be recognized - presumably at the maximum 25% federal rate for real estate capital gains.(6))
There are a number of factors that must be considered when determining whether to take qualified home office expenses. Often overlooked is the impact that the additional deduction will have on self-employment tax and on any self-employed pension plan deduction. Since these two items will be reduced, the associated adjustments reducing adjusted gross income will also be reduced, lessening the income tax impact of the home office deductions. (Additionally, as both these items are actually contributions to future retirement benefits, this reduction may not be desired, although it will reduce cash flow needs.)
There are obviously other cases where it would be to the taxpayer's advantage to take the deduction. If the taxpayer is fairly certain that the residence will not be sold at a gain in the future and if the home office expenses are large enough to warrant the additional risk of IRS scrutiny, it may make sense to take the deduction. Or if, as noted above, the taxpayer makes numerous trips to various clients from the home office the related mileage expense may help justify taking the home office deduction. In addition, if expenses not otherwise deductible are large enough it may make sense to take the deduction.
For those individuals comparing an office in the home to a conventional out-of-home office other considerations should be addressed. A claim for home office deduction on a tax return establishes that the taxpayer has a business in the home could impact other, non-tax areas. For example, homeowner's insurance policies may not fully cover business property or injuries of business clients. Also, local governments may have zoning restrictions and neighbors may object, particularly if there are clients coming to the office. In addition, the property tax assessment may change for the business portion of the home, since business property may be taxed at a different rate than residential. Home-owners exemptions may also be affected since the exemption usually does not apply to the business portion of the residence. If clients come to the office, the house may have to altered to meet fire safety standards or to provide access to those with disabilities. This could involve the installation of sprinklers, elevators or ramps in addition to making restrooms available to those with wheelchairs.
Also, while the IRS does not release information on what items trigger an examination, many practitioners, including the authors of this article, believe that deductions for home office weigh heavily in the screening process. Certainly, an examination that is scheduled can be expected to include careful scrutiny of the home office qualification and expenses.
There will probably be many taxpayers who elect to take the home office deduction for 1999 without doing the detail work necessary to see if it really makes financial sense. Some of these same taxpayers may find themselves paying taxes on the future disposition of the property that exceeds the benefits derived from claiming the home office deduction. Since each taxpayer has unique circumstances, the only way to make the correct decision is to examine each case individually.
Generally, the home office deduction doesn't make a great deal of tax difference with taxpayers who will have relatively minor net deductions or that have pension plans that are based on the income of the home-based business and/or whose FICA is based entirely on the business self employment. Additionally, those who expect to ultimately sell their home may find the tax on the gain attributed to the home office area will be more than the tax savings achieved by deducting the office.
Those with access to a microcomputer and tax preparation software can do "what if" analysis by comparing tax results with, and without, the home office deduction. Don't forget to test for sale of the residence to see the effect of the gain, if any. This will give an approximate annual tax savings but will not consider the time value of money. The author's testing template (See below.) is available on the World Wide Web for evaluation purposes. This template will require a minimum of input and will provide information about the with and without total tax and the present value of the differences.
To Download Home Office Spreadsheet
1. IRC Section 280A
2. IRC Section 280A
3. IRC Section 1016(a)(2); Virginian Hotel Corp., 43-1 USTC 9469; 319 US 525
4. 101 T.C. 537 (1993)
5. IRC Section 121(d)(6)
6. IRC Section 1(h)(7)(A)
5. IRC Section 121(d)(6)
6. IRC Section 1(h)(7)(A)