Can the cost of a home computer be written off?

EXECUTIVE SUMMARY

A taxpayer who buys a computer for home use in a trade or business, for investment use or use as an employee faces a barrage of Code provisions and regulations designed to restrict the ability to depreciate or expense such equipment. To increase complexity, even if a deduction is currently available, it may have to be recaptured later on. This article provides a detailed explanation through the minefield of rules and offers planning suggestions so that available deductions can be maximized.

The proliferation of home computers raises the inevitable question of whether the cost of such equipment can be expensed or depreciated. The answer depends on whether the computer is used for:

1. Business use.

2. Investment use.

3. Use as an employee.

4. Personal use.

Deductions are not permitted for personal use of a computer; however, a computer may be depreciable if put to one of the other uses. In addition, if certain requirements are met, Sec. 179 allows the expensing of up to $17,500 of the cost of the computer in the year placed in service. Any amount not written off under Sec. 179 may be eligible for the double-declining balance (DDB) method with a five-year useful life, under the modified accelerated cost recovery system (MACRS).(1)

Depreciating a Home Computer

Sec. 280F restricts the use of accelerated depreciation and the ability to make a Sec. 179 election for "listed property." Sec. 280F(d) (4) (A) (iv) includes in the definition of "listed property" any computer or peripheral equipment.

A computer used more than 50% of the time for a "qualified business use" (QBU) of the taxpayer can be depreciated using the DDB method and a five-year life; alternatively, the cost can be expensed under Sec. 179.(2)

If the computer is used 50% or less of the time in a QBU, it must be depreciated using straight-line over five years under the ADS and is not eligible for Sec. 179.(3) A taxpayer using MACRS whose QBU falls to 50% or less may be required to recapture part of the deductions previously taken, under Sec. 280F(b) (2) (A).

The percentage of time the computer is used for a QBU is determined in the year it is placed in service, according to Sec. 280F(d) (6) (A). Even if the QBU increases from 50% or less in the year placed in service to more than 50% in a later year, the taxpayer will nonetheless be required to continue using straight-line depreciation and cannot elect Sec. 179. Consequently, the taxpayer should consider purchasing the computer in a year in which the greater-than-50% requirement can be met.

Sec. 280F(d) (6) (B) and Temp. Regs. Sec. 1.280F-6T(d) (2) (i) define a QBU as any use in a trade or business of the taxpayer, but not an investment use, a distinction discussed below.

Example 1: J purchases a computer on Feb. 1, 1996, which he uses 40% of the time in his business, 20% of the time to manage his investments and 40% of the time for personal use. The time J spends managing his investments and on personal use does not count as a QBU. Consequently, J must use straight-line depreciation and cannot elect Sec. 179 treatment.(4)

Depreciation for Business and Investment Use

The taxpayer first must determine whether accelerated or straight-line depreciation is appropriate, based on the QBU. Once the appropriate method is determined, the taxpayer may depreciate the computer for both the business and investment uses, as defined in Temp. Regs. Sec. 1.280F-6T(d) (3) (i). Business depreciation is reported on Schedule C, Part II, line 13; investment depreciation is reported on Schedule A, line 22 as a miscellaneous itemized deduction. The investment use portion of depreciation will be deductible only if the taxpayer itemizes and then only to the extent such depreciation, when added to other miscellaneous expenses, exceeds 2% of adjusted gross income.

Example 2: P purchases a computer in February 1996 for $5,000. He uses the computer during 1996 as follows: 40% for business, 30% for managing investments, and 30% for personal use. Because P's QBU is less than 50%, he cannot make a Sec. 179 election and must use straight-line ADS depreciation. If P purchased no other equipment in 1996, he would use the mid-year convention and depreciate the computer based on the 70% mixed business and investment use. Thus, in 1996, the depreciation deduction is $350 (70% X $5,000 X 1/5 (five-year life) X 1/2 (half-year convention)); $200 is deducted on Schedule C and $150 is deducted on Schedule A.

In 1997, P increases the business use to 60% and the investment use to 35%. P cannot switch to accelerated depreciation or elect Sec. 179. The only relevant year to determine QBU is 1996, the year the computer was placed in service. The depreciation for 1997 is $950 ($5,000 X 95% (business/investment use) X 1/5 (five-year life, straight-line depreciation).

Thus, P should have considered limiting the personal or investment use of his computer in 1996 so that he spent more than 50% of the time in a QBU, allowing the use of accelerated depreciation or Sec. 179. However, if at any time during the recovery period the QBU falls below 50%, the deductions taken will be subject to recapture.

Depreciation after the end of the recovery period: Although computers have a five-year MACRS life, because either the half-year or midquarter convention is used in the year of purchase and in the year of disposition, the computer is actually depreciated over six years. In determining the unrecovered basis available for depreciation in later years, the basis of the asset is reduced as if the computer were used entirely for business. The percentage of time spent on personal use is ignored.(5)

Example 3: P purchases a computer and uses it for business and investment as follows: years 1, 2 and 3, 60%; years 4, 5 and 6, 70%. Even though P used the computer less than 100% for business and investment use in the first six years, the adjusted basis will be calculated as though he used it 100% for business. Consequently, there will be no remaining adjusted basis and P will not be entitled to depreciation in year 7 or thereafter.(6)

Sec. 179 Election

Sec. 179(b) (1) and (d) (1) permit a taxpayer to elect to expense up to $17,500 of the cost of tangible depreciable personal property purchased for use in a trade or business. A new or used computer qualifies for the Sec. 179 election. The taxpayer must use the property more than 50% of the time in the active conduct of a trade or business.(7) According to Regs. Sec. 1.179-1 (d) (1), the percentage of the cost attributable to business, not the percentage attributable to investment use, is eligible for a Sec. 179 election. If business use falls to 50% or less in any year during the recovery period, recapture rules apply under Sec. 179(d) (10).

Under Sec. 179(a), the expense election is available only in the year in which the computer is placed in service; if the taxpayer uses the computer solely for personal purposes in the year of purchase, but converts it to business use in a later year, the ability to make the election is lost. A Sec. 179 deduction is available regardless of when the computer is placed in service during the year.(8) According to Secs. 280F (d) (1) and 168 (a), the Sec. 179 deduction reduces the basis of the computer; any remaining basis is subject to MACRS depreciation beginning in the year the computer is placed in service.

Regs. Sec. 1.179-5 (a) provides that a Sec. 179 election, which is irrevocable without IRS consent, is made on Form 4562, Depreciation and Amortization, for the tax year to which the election applies (whether or not the return is timely) or on a timely filed amended return (including extensions). Under Regs. Sec. 1.179-5 (a) (2), the taxpayer must keep records showing from whom the property was acquired and when it was placed in service.

Example 4: On Nov. 1, 1996, M purchased a computer for $5,000, which she uses 60% for business, 20% for investment and 20% for personal use. Only $3,000 (60% (the business portion) X $5,000) may be deducted under Sec. 179 in 1996. Even if M increases her business use to 100% in 1997, she will not be able to expense any additional amount. M reduces the $5,000 basis by the $3,000 expensed under Sec. 179 and can depreciate the remaining $2,000 basis using MACRS accelerated depreciation beginning in 1996. If no other items of tangible personal property are placed in service in 1996, M is required to use the mid-quarter convention (because more than 40% of the tangible personal property acquired during the tax year is placed in service during the last quarter). M's 1996 depreciation deduction is $80 ($2,000 X 80% (business/investment use) X 1.5/12 (acquired in the last quarter) X 40% (five-year DDB method)). The total deduction in 1996 is $3,080 ($3,000 expensed, $80 depreciated).

Sec. 179 expensing avoids application of the depreciation conventions. Although M acquires the computer in November, she is not required to apply the mid-quarter convention to the $3,000 she elected to expense under Sec. 179. If M had instead elected to depreciate the computer under MACRS, the mid-quarter convention would have applied and M would have been able to deduct only $200 ($5,000 X 80% X 40% (five-year life, DDB method) X 1.5/12 (mid-quarter convention)).

There are two further limits on the expense deduction--the taxable income limitation (TIL) and the ceiling limitation (CL). The Sec. 179(b) (2) CL requires the $17,500 maximum deduction to be reduced if the amount of qualifying property placed in service during that tax year exceeds $200,000. for this purpose, a husband and wife who file a joint return are treated as one taxpayer, under Regs. Sec. 1.179-2 (b) (5) (i). Those who are married filing separately are also treated as one taxpayer, and, unless they elect otherwise, are allocated the cost equally, under Sec. 179 (b) (4) and Regs. Sec. 1.179-2 (e) (1).

The TIL caps the deduction at the aggregate taxable income from all of the taxpayer's active trades or businesses.(9) However, any amount not deducted because of the TIL may be carried over to future years, under Sec. 179 (b) (3) (B).

The Sec. 179 election is generally desirable even if there is inadequate income from the trade or business in the current year to take the full deduction. Because the excess can be carried over, the tax savings will be greater than depreciating the asset over its useful life.

The taxpayer must aggregate the income from all active businesses he conducts for TIL purposes; according to Regs. Sec. 1.179-2 (C) (6) (i) and (iv), this does not include income from property held for the production of income or activities not engaged in for profit, but does include income from wages, salaries and other employee income. Regs. Sec. 1.179-2(c) (1) provides that, for TIL purposes, taxable income is computed without regard to (1) the Sec. 179 expense deduction; (2) the Sec. 164(f) deduction for one-half of the self-employment tax; (3) any net operating loss carryback or carryforward; and (4) any deductions suspended under other Code sections.

A husband and wife who file a joint return must, under Regs. Sec. 1.179-2(c) (7) (i), combine any income from their separate businesses in computing the TIL. Married individuals who file separately must compute their TILs separately, according to Regs. Sec. 1.179-2(c) (8).

Example 5: H and W file jointly for 1996. H has taxable income from his sole proprietorship of $30,000; W has a taxable loss from her business of $26,000. In 1996, W purchases computer equipment for $10,000, for which she elects Sec. 179. H and W's combined income for purposes of the taxable income limitation is $4,000 ($30,000 + (-$26,000)); thus, $4,000 of the computer's cost is deducted in 1996 and the $6,000 balance is carried forward. The carryover can be deducted in 1997 to the extent that, when added to the expense election for that year, it does not exceed either the $17,500 or $200,000 limitation. Any amount that exceeds those limits in 1997 can be further carried forward.

Recapture

If at any time during the recovery period the taxpayer's business use of the computer falls to 50% or less, the taxpayer will be required to recapture the "excess depreciation" previously taken, under Sec. 280F (b) (2) (A); further, under Sec. 280F (b) (1), only straight-line depreciation will be available in future tax years. Recapture also applies if the taxpayer disposes of the property or stops using it in his business.(10)

Sec. 280F (b) (2) (B) defines "excess depreciation" as the excess of (1) the depreciation allowable (including under Sec. 179) for tax years before the first tax year in which the property is not used predominantly (i.e., more than 50% of the time) in a QBU over (2) the depreciation that would have been allowable for those years if the property had not been used more than 50% of the time in a QBU for the year it was acquired and there had been no Sec. 179 election for the property.

Example 6: L purchases a computer for $5,000 in 1996 and uses it 100% of the time in a QBU. He expenses it under Sec. 179. On Jan. 1, 1997, L gives the computer to his son as a gift and it is no longer used for business or investment purposes. In 1997, L must include in income $4,500 ($5,000 (the amount expensed in 1995) -- $500 (the amount that would have been allowable under straight-line depreciation in 1996 [$5,000 X 1/5 X 1/2])).

Computer Software

If computer software is included in the purchase price of the computer hardware without being separately identified, the total cost of both is capitalized and depreciated over the five-year life of the hardware or expensed under Sec. 179(11) Sec. 167(f) (1) provides that if the software is purchased at a different time and used for business or investment purposes, it is depreciable straight-line over 36 months.(12)

Substantiation

There are strict substantiation rules for listed property. Under Temp. Regs. Sec. 1.280F-6T (e) (3), the taxpayer must keep track of the amount of time he uses the computer for business, investment and personal use; under Temp. Regs. Sec. 1.274-5T (c) (1), he must be able to substantiate the business and investment use by adequate records or by sufficient evidence corroborating his own statement. To accurately keep track of the various uses of the computer, the taxpayer should maintain a log with entries made at or near the time the computer is used. Temp. Regs. Sec. 1.274-5T (c) (2) (ii) (C) (2) provides that the log can be maintained manually or prepared with the aid of a logging program and retained in the computer's memory.

According to Temp. Regs. Sec. 1.274-5T (c) (1), a contemporaneous log is not required, but a record made at or near the time of use is more probative than is a statement prepared afterward. Written evidence is far more convincing to the IRS than is oral evidence.

Even if the taxpayer has fully expensed the cost of the property under Sec. 179, he is still required to maintain records for the entire recovery period. The IRS has imposed this burdensome requirement because of the recapture rules. To avoid recapture, Temp. Regs. Sec. 1.280F-3T (d) (3) provides that the taxpayer must be able to document that the QBU is more than 50% for each year of the recovery period.

Distinguishing Investment Use From Business Use

The taxpayer must distinguish between business use and investment use of the computer. Although the phrase "trade or business" is used repeatedly throughout the Code, it is not explicitly defined. According to the Supreme Court's decision in Groetzinger,(13) a taxpayer need not hold himself out as engaging in the sale of goods or services, but must be engaged in a regular and continuous activity with a profit motive. A taxpayer can have more than one trade or business.

Using the computer to manage one's own investments is generally considered an investment activity. However, if the taxpayer is classified as a "trader," he is engaged in a trade or business. To be considered a "trader," the taxpayer's income must be earned primarily from short-term purchases and sales of stock and securities, instead of from interest, dividends or long-term appreciation. For example, in Moller,(14) a husband and wife who held $14 million of securities and executed 83 purchases and 41 sales in one year were held not to be engaged in a trade or business, because most of their income was derived from dividends, interest and investments held for long-term appreciation, even though they spent nearly full-time managing their securities. Moller was decided before Groetzinger; the result might be different today, because the activity there appears to have been regular and continuous.

The rental and management of a residential property or an apartment building is a trade or business if the activities are substantial, regular and continuous. For example, in Curphey,(15) the taxpayer worked 40 hours a week as a dermatologist. He also owned six rental properties for which he supervised the repairs and maintenance. The Tax Court held that he was engaged in a trade or business. Leasing a single piece of real property to another entity may also be a trade or business.(16)

Use of a Computer by an Employee

An employee is deemed to be engaged in the trade or business of providing services to his employer. Sec. 280F(d) (3) (A) imposes two requirements for an employee to depreciate or expense under Sec. 179 a purchased or leased computer--the use of the computer must be for the "convenience of the employer" and "required as a condition of employment." There is no deduction if these two requirements are not met.

Temp. Regs. Sec. 1.280F-6T (2) (i) states that the terms "convenience of the employer" and "condition of employment" have the same meaning for Sec. 280F purposes as they do for Sec. 119 (relating to the exclusion from gross income for meals and lodging furnished for the convenience of the employer). Regs. Sec. 1.119-1 (a) defines "convenience of the employer" as a "substantial noncompensatory business reason of the employer," as determined by an analysis of the facts and circumstances.

To satisfy the "condition of employment" requirement, the use of the property must be required for the employee to properly perform the duties of employment. The employer need not explicitly require the employee to use the property; however, a mere statement by the employer that use of the property is a condition of employment is not sufficient, according to Temp. Regs. Sec. 1.280F-6T (a) (2) (ii).

The Conference Report to the Deficit Reduction Act of 1984(17) indicated that the principles of Dole(18) apply in determining whether the condition of employment test is met. In Dole, three key employees of a woolen mill were required to live in housing one mile away so that they could be available in case of emergency. The closest other housing was three miles away. The Tax Court held that the value of the housing was taxable, concluding that the taxpayers were not required to accept the lodging provided by their employer to perform properly the duties of their employment. The fact that the president of the employer company insisted that the taxpayers occupy the company-owned houses to help promote the efficient operation of the mill did not, by itself, mean that the statutory standard (i.e., required as a condition of employment) was met. The employer's state of mind was not controlling.

The IRS interprets "condition of employment" for use of personal computers even more stringently than under Sec. 119; the standard seems to be that the employee must show that it would be impossible for him to properly perform his duties without the use of a computer. The fact that the computer helps the employee perform his duties of employment more easily and efficiently is not enough.

For example, in Rev. Rul. 86-129,(19) the taxpayer was an aerospace engineer engaged in research for his employer. He purchased a computer for home use because the computers at work were often occupied during working hours by other employees and he often performed work at home. The computer was used exclusively for the performance of services for his employer and the employer provided him with a written statement that he was required to purchase the computer as a condition of employment. However, the IRS ruled that the computer was not required as a condition of employment; there was no evidence that the computers supplied by the employer were insufficient to enable the taxpayer properly to perform the duties of his employment and no clear showing that the taxpayer could not perform properly his duties without a home computer.

In Letter Ruling 8725067,(20) a computer staff analyst was required to be on call 24 hours a day to correct problems on computer systems that linked manufacturing plants, sales offices and distribution centers nationwide. Without a portable computer, the taxpayer would have traveled between 30 and 50 miles to a computer site. The added time would have caused excessive computer down-time. The IRS held that the computer was not necessary for the employee to properly perform his duties.

Only if there is no computer available at work does the taxpayer seem to have a convincing argument for a Sec. 179 election or depreciation. In Cadwallader,(21) the Tax Court permitted a psychology professor and his wife, a transportation planner, to deduct the cost of a computer. The professor was expected to conduct research as a part of his job, which required the use of a computer. Neither spouse's employer provided access to a computer or explicitly required the purchase of a computer as a condition of employment. The court held that the "convenience of employer" requirement was satisfied because the purchase spared the taxpayers' employers the cost of providing them with a computer. The "condition of employment" requirement was also met because the taxpayers' computer was required to properly perform their respective duties of employment.

Conclusion

Taxpayers will prefer to deduct the cost of a computer under Sec. 179, but will only be able to do so if they use the computer more than 50% of the time for business. Otherwise, they can depreciate the computer based on business and investment use. Accelerated depreciation can be used if business use exceeds 50%. Accurate records of the business and investment use must be maintained. Employees will be able to deduct or depreciate the computer only if they can prove that it is for "the convenience of the employer" and a "condition of employment," tests the IRS interprets very narrowly.

(1) See Secs. 280F(d) (4) (iv), 168(e) (3) (B) (iv), (i) (2) (A) (i), and (i) (2) (B) (i) (1). Alternatively, the taxpayer can elect to use the alternative depreciation system (ADS), which permits use of either the 150% declining balance or the straight-line method over a five-year life; see Sec. 168(b) (2) (C), (3) (D) and (5).

(2) See Temp. Regs. Sec. 1.280F-3T(c) (1); the QBU test can be avoided altogether, and the computer will not be listed property, if the taxpayer meets the requirements of Sec. 280F(d) (4) (B).

(3) Secs. 280F(b) (1) and 168(g) (3) (C); Temp. Regs. Sec. 1.280F-3T(c) (1).

(4) See Temp. Regs. Sec. 1.280F-3T (f), Example 1.

(5) Sec. 280F (d) (2); Temp. Regs. Sec. 1.280F-4T (a) (1).

(6) Temp. Regs. Sec. 1.280F-4T (a) (1).

(7) Sec. 179(d) (1); Regs. Sec. 1.179-1 (d) (1).

(8) Sec. 179(a); Regs. Sec. 1.179-1(c) (1).

(9) Sec. 179(b) (3) (A); Regs. Sec. 1.179-2(c) (1).

(10) Sec. 280F (b) (2) (A); Temp. Regs. Sec. 1.280F-3T (d) (1).

(11) Rev. Proc. 69-21, 1969-2 CB 303, Section 4.01.

(12) Sec. 197 15-year amortization may apply to customized software acquired in connection with the acquisition of a trade or business.

(13) Robert P. Groetzinger, 480 US 23 (1987) (59 AFTR2d 87-532, 87-1 USTC [paragraph]9191), aff'g 771 F2d 269 (7th Cir. 1985) (56 AFTR2d 85-5683, 1985-2 USTC [paragraph]9622).

(14) Joseph A. Moller, 721 F2d 810, 813 (Fed. Cir. 1983) (52 AFTR2d 83-6333, 83-2 USTC [paragraph]9698), cert. denied.

(15) Edwin R. Curphey, 73 TC 766 (1980).

(16) See Thomas B. Fegan, 71 TC 791 (1979).

(17) H. Rep. No. 98-861, 98th Cong., 2d Sess. 1027 (1984), 1984-3 (Vol. 2) CB 281.

(18) Gordon S. Dole, 43 TC 697 (1965), aff'd, 351 F2d 308 (1st Cir. 1965) (16 AFTR2d 5756, 65-2 USTC [paragraph]9688).

(19) Rev. Rul. 86-129, 1986-2 CB 48.

(20) IRS Letter Ruling 8725067 (3/25/87).

(21) Thomas C. Cadwallader, TC Memo 1989-356, aff'd on another issue, 919 F2d 1273 (7th Cir. 1990) (67 AFTR2d 91-301, 90-2 USTC [paragraph]50,597).