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The Expanded Home Office Deduction Rules Make It Easier For The Taxpayer To Qualify.

Every year, thousands of people perform some type of business activity in their homes. Until 1993, many of these people who had home offices qualified for tax deductions. [1] In 1993, the U.S. Supreme Court interpreted IRC Sec. 280A in such a manner that it became very difficult for most taxpayers to qualify for a home office deduction. When Congress passed the Taxpayer Relief Act of 1997 (TRA 97), it included a provision that allows more taxpayers to qualify for a home office deduction. Although the TRA 97 was passed in 1997, the provision that pertains to home office deductions did not become effective until after December 31, 1998.

This article examines the rules concerning home office deductions, discusses other deductions that are closely associated with the home office, and examines potential pitfalls associated with the home office deduction. It is important to note that in defining the term home office; "home" can be a house, apartment, condominium, mobile home or boat. [2]

BACKGROUND

Pre-Soliman

Prior to the Soliman case, Section 280A (c)(1) stated that in order for a taxpayer to deduct home office expenses, the office had to be used "exclusively" and on a "regular basis" as:

(1) The principal place of business for the taxpayer's trade or business, or

(2) A place of business which is used by patients, clients, or customers in meetings with the taxpayer in the normal course of business.

Principal Place of Business

The term "principal place of business" was, at that time, defined as the location where persons earn their income. This definition made it impossible for plumbers, electricians and interior decorators to qualify for the deduction because these people earned their income at locations other than in their offices. Both the IRS and the courts have stated that the taxpayer must be involved in a trade or business and that activities such as clipping coupons or reading investment magazines do not constitute a trade or business. [3]

Regular

The term "regular" means that a specific area of the house is used on a continuous basis. Occasional or incidental use does not meet the test. [4] Even if the area is not used for any other purpose, it still fails the test if the area is used only occasionally. Neither the courts, nor the IRS, have specifically stated how many hours per day (or per week) that the office must be used for business purposes. All available authority indicates that the time element depends on the circumstances. [5]

Exclusive

The term "exclusively" means that the office is only used for business purposes. If the area is used eight hours a day for business, but the children come in at night and play video games on the computer, the office fails the exclusive use test and the deduction is lost.

There are two exceptions to the "exclusive use" test. If the taxpayer is in the business of selling products, the area of the home that is used to store inventory does not have to meet the exclusive use test. [6] The storage space must be, however, a specific, and identifiable area.

Example

Sue is a cosmetics distributor. She uses her kitchen closet to store her inventory of cosmetics. Even though she uses the closet to store canned goods, as well, the area is still deductible as part of her home office.

Another situation that is exempt from the exclusive use test is when the home is used regularly to provide day-care services to children, handicapped persons, or the elderly. The home office deductions for a daycare service is computed as follows:

Expenses x Square footage used for day care/Total square footage of home x Hours of operation per year/Total hours per year

Soliman v. U.S.

In the Soliman case, an anesthesiologist was employed by three different hospitals, but was not provided an office at any of them. He spent a total of approximately 35 hours per week at the hospitals and another 10-15 hours per week at his home office where he kept patient records, performed billing functions and read medical journals. In its ruling, the Supreme Court established a two-part test to determine whether a home office does in fact constitute a principal place of business. The two parts are relative importance and time.

The first part of the test examines the functions performed at each location in an attempt to determine where the most important activities take place.

The time portion of the test compares the amount of time actually spent at each of the various locations. In order to pass this part of the test, more than 50% of the taxpayer's time must be spent working in the home office.

The Supreme Court concluded that Soliman failed to meet the relative importance test because the activities he performed at home were of an administrative and management nature. These tasks were not nearly as important as the activities he performed at the hospital, such as anesthetizing patients for surgery and conferring with other doctors. The decision stated that the medical procedures Dr. Soliman performed at the hospital constituted the "essence" of his business and, therefore, the home office was not his principal place of business. Furthermore, the Supreme Court ruled that since he spent considerably more time at the hospital than in his home office, he also failed the time test. Thus, his deduction was disallowed.

WHO QUALIFIES FOR THE DEDUCTION?

By amending IRC Sec. 280A (c) via TRA 97, Congress recognized that almost every business needs a location where the business owner can store records, complete paperwork and take care of other administrative tasks. Accordingly, the TRA 97 expands the definition of the term "principal place of business" so a deduction can be taken if:

(1) The home office is used to conduct administrative or management activities of the trade or business. If taxpayers are unable to qualify under the new test, they may still qualify for the deduction under the old "relative importance" and "time" test. [7]

(2) The taxpayer has no other fixed location in which to conduct a substantial amount of administrative or management activities. If an insignificant amount of management and administrative work is performed elsewhere, this will not disallow the deduction.

(3) The office is used exclusively and on a regular basis for a trade or business.

(4) If the taxpayer is an employee, the home office is maintained for the convenience of the employer.

Requirements three and four were in effect under the old law. These requirements must be met whether the taxpayer is attempting to qualify his office as the principal place of business under the old law or the new.

What Items are Deductible?

Deductible expenses include a pro rata percentage of real estate taxes, mortgage interest, utilities, insurance, and depreciation. [8] If customers visit the taxpayer's home on a regular basis, the cost of landscaping and recurring lawn care are included. [9] Repairs that benefit only the business portion of the home are classified as direct expenditures and are fully deductible. Examples include painting or recarpeting the office. Repairs that benefit the entire residence are classified as indirect expenditures and are deductible on a pro rata basis. Painting the entire house or replacing the roof are considered indirect expenditures. [10]

The following IRS guidelines must be observed when computing depreciation on the office:

* Non-residential real property placed in service before May 13, 1993 is depreciated over 31.5 years, whereas nonresidential real property placed in service after May 12, 1993 must be depreciated over 39 years.

* If a building was placed in service before 1987, it can be depreciated using accelerated depreciation. If it was placed in service after 1986, the taxpayer must use straight-line depreciation.

* The amount to be depreciated is the lower of the fair market value of the residence at the time it is placed in service or the adjusted basis, which is the original purchase price, plus the cost of any improvements less any allowance for cost recovery.

The first step in computing depreciation is to multiply the percentage of the residence used for business by the smaller of the adjusted basis or the fair market value at the time placed in service. The resulting figure is the depreciable basis. Next, the depreciable basis is multiplied by the appropriate percentage from a table to determine the depreciation deduction. Tables are available in Revenue Procedure 87-57, 1987-2 CB 687.

The depreciation in Table I is used the first year an asset is placed in service. The percentages are based on an asset life of 39 years, the straight-line method, and the mid-month convention. Since the residence in the following example was first placed in service during April, the mid-month convention requires that 8.5 months be used to calculate the cost recovery allowed--eight months for May through December and one half month for April. The computation is as follows:

100%/39 X 8.5/12 = .01819

In subsequent years, the applicable percentage is: 100%/39 = 2.5641

Example

In April 1999, Dustin began using one room in his house for business purposes. The room constitutes 10% of the home's total square footage. The adjusted basis of the residence (not including land) is $100,000. In April the fair market value of the house (not including land) was $113,000. Since the adjusted basis is less than the fair market value, the adjusted basis will be multiplied by 10% to obtain the depreciable basis of $10,000. Because the residence was placed in service during April, the fourth month of the year, the $10,000 basis will be multiplied by 1.819% (.01819) resulting in a depreciation deduction of $181.90.

Computing the Amount of the Deduction

The home office deduction for a sole proprietorship is reported on Schedule C of Form 1040. Form 8829 "Expenses for Business Use of Your Home" must also be attached.

The amount of the home office deduction is limited to the difference between the business gross income and the non-home office business expenses such as advertising, salaries and supplies. Thus, the home office deduction can only be large enough to reduce net income to zero. The deduction cannot create or increase a net loss. [11]

The order in which home office deductions are allowed to offset gross income is important. The first items deducted are those that would have been allowed anyway; e.g., mortgage interest, property taxes, and casualty losses if any. The next deductions allowed are those deductible by any business activity, such as utilities and repairs. Finally, the taxpayer may deduct depreciation. Only the business percentage of the home may be depreciated. Any expenses that exceed the net loss limitations are carried over to subsequent years, subject to the same rules that were in effect the year the loss took place. The example below illustrates these rules.

The remaining depreciation of $200 ($900 minus $700) may be carried over into future tax years.

As with all deductions, record keeping is important. The taxpayer should keep a separate business checking account, as well as a log of business meetings with clients, and save business receipts.

It Just Keeps Getting Better and Better

For most taxpayers, travel from their home to their first business stop of the day is a non-deductible commuting expense. Likewise, the trip home in the evening from the last business stop of the day is non-deductible. As an added bonus for those taxpayers who qualify for the home office deduction, all business-related travel costs from the taxpayer's home office to clients' offices and back are deductible.

Another bonus associated with the home office deduction is a special rule for property available for both business and personal use. This property is known as "listed property." Computers are normally subject to the listed property rules of IRC Section 280F. Listed property can be expensed or depreciated on an accelerated basis only if it is used more than 50% of the time for business purposes. This requirement results in a tremendous amount of detailed record keeping. However, there is an exception to this rule for computers used in a business establishment. [12] And, a home office qualifies as a business establishment. Thus, taxpayers who qualify for a home office deduction are spared a great deal of recordkeeping regarding the use of their computers.

I Knew There Was a Catch

When a personal residence is sold and the taxpayer has owned and lived in the house as a personal residence for at least two of the five years prior to the sale, up to $250,000 of the gain ($500,000 if married filing jointly) is tax free.

It should be noted that depreciation taken after May 6, 1997 may have to be recaptured. Generally, recapture refers to the portion of accelerated depreciation that is treated as ordinary income at the sale of the property. However, this type of recapture occurs even though no accelerated depreciation has been claimed. This recaptured depreciation is not treated as ordinary income but is taxed at 25%.

Example

A single taxpayer in the 28% tax bracket used a portion of his home as an office and claimed depreciation of $9,000, of which $3,000 was taken after May 6, 1997. The residence sold at a gain of $200,000. Assuming that the ownership and use tests of Sec. 121 were met, the only tax consequences are that the $3,000 of depreciation taken after May 6, 1997 is recaptured and taxed at 25%, resulting in a tax liability of $750.

SUMMARY

In 1993, the Supreme Court ruled that in order for a taxpayer to claim a deduction for an office in the home, the office must constitute the taxpayer's principal place of business. The Supreme Court defined this term as the place where the most important aspect of the taxpayer's trade or business is performed. This ruling prohibited a large number of taxpayers from claiming a home office deduction.

Congress passed the TRA 97 to overcome the Supreme Court's ruling. This made the home office deduction available to anyone who uses a home office for either managerial or administrative functions, even though the actual work is performed elsewhere.

Many taxpayers believe that claiming a home office deduction will almost guarantee an audit. However, the authors believe that keeping good records associated with the business use of the home should prevent any IRS adjustments. A business checking account with cancelled checks, separate telephone lines, and a diary of meetings with clients are the types of documentation needed to survive an audit.

Lee Daniel, MPA, CPA is an Associate Professor of Accounting at Sorrell College of Business at Troy State University in Troy, AL.

Dr. Leonard G. Weld is an E.H. Sherman Professor of Accounting and Chair of the Accounting and Finance Department at Sorrell College of Business at Troy State University in Troy, AL.

References

(1.) Soliman v. Com., 93-1 USTC [footnote number] 50,014; 113 S.Ct. 701 (1993).

(2.) Sec. 280A (f)(1)(A).

(3.) J.A. Moller v. U.S., 83-2 USTC [footnote number] 9698; 721 F2d 810 (CA-FC).

(4.) Prop. Reg. [sections] 1.280A-2 (c).

(5.) Prop. Reg. [sections] 1.280A-2 (h).

(6.) Sec. 280A (c)(2).

(7.) Sec. 280A(c)(1)(c).

(8.) Sec. 280A (f)(4).

(9.) Hefti v. Comm., CCH Dec. 44,527 (M); 54 TCM 1555.

(10.) Prop. Reg. [sections] 1.280A-2 (i) (3).

(11.) I.R.C. Sec. 280A (c)(5).

(12.) Sec. 280F(d)(4)(6).
 First Year MACRS Table
 For Non-residential Real
 Property Placed in Service
 after May 12, 1993
FIRST MONTH OF
BUSINESS USE PERCENTAGE TO USE
1 (January) 2.461%
2 2.247%
3 2.033%
4 1.819%
5 1.605%
6 1.391%
7 1.177%
8 0.963%
9 0.749%
10 0.535%
11 0.321%
12 (December) 0.107%


Example

Derek is a taxidermist who uses a room in his house regularly and exclusively for business. The floor space used for business constitutes 10% of the floor space of the entire residence. Gross income from the business is $10,000. Expenditures for advertising, supplies, and the salary of a part-time assistant total $8,000. Derek incurs the following home office expenses:
Property taxes on residence $ 3,000
Interest expense on residence 6,000
Utilities, repairs and insurance on
 residence 4,000
Depreciation on business portion of the
 residence 900
Derek's home office deduction is
 computed as follows:
Gross income $10,000
Less: Other business expenses 8,000
 $ 2,000
Less: Business portion of taxes (10% of
 $3,000) 300
Business portion of interest (10% of
 $6,000) 600 900
Remaining income $ 1,100
Less: Business portion of
utilities and insurance (10% of 4,000) 400
 $ 700
Less: Depreciation on business portion
 ($900, but limited to remaining
 income) 700
 Net Income of the business -0-
COPYRIGHT 2000 National Society of Public Accountants
No portion of this article can be reproduced without the express written permission from the copyright holder.
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Author:Daniel, Lee; Weld, Leonard G.
Publication:The National Public Accountant
Geographic Code:1USA
Date:Dec 1, 2000
Words:2811
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