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Home-office deduction dilemma: to deduct or not.

The Tax Relief Act of 1997 (TRA97) provided important changes in the home-office rules. These rules took effect for 1999 tax returns. New rules, as a result of TRA97, eliminate one of the major barriers, while retaining most of the original rules.(1)

In general, a taxpayer may deduct business expenses that apply to a part of his or her home only if that part of the home is used exclusively and on a regular basis for business purposes. Previously, the term "business purposes" was defined narrowly by the IRS for this deduction. It was defined as either the principal place of business for the taxpayer's trade or business, or as a place of business used by patients, clients, or customers to meet or deal with the taxpayer in the normal course of business, except for storage space for inventory. That definition posed a problem for many businesses that did not meet clients at a home office, but rather, due to the nature of the work, met clients at a work site. The new rules expand the definition of principal place of business to include the exclusive and regular use for administrative and management activities, if the taxpayer has no other fixed location where he or she conducts such activities.(2)

The new definition was tested in a case involving a Los Angeles violinist, Katia Popov. The recent ruling by a federal appeals court allowed her to take a home-office deduction for her one-bedroom apartment's living room, which is where she practiced and stored music.(3) Although the space must still meet the rule concerning exclusive use, clearly there is more opportunity for individuals to utilize this deduction.

What Are the Real Benefits of the Home-Office Deduction?

The benefits of deducting home-office expenses may seem clear at first and, quite frankly, many clients feel it is too good to pass up. But the issue can get complicated. Sometimes the real benefit is not as great as it appears on IRS Form 8829 (expenses for business use of your home).

For example, after calculating the portion of the home used exclusively for business, usually utilizing the percentage of square footage method, some deductions simply move from Schedule A to Form 8829. Examples of these include interest and real estate taxes paid on the home. If an individual is eligible to itemize anyway, those items do not create additional deductible amounts. However, by moving them to the 8829, they do reduce Schedule C income and, therefore, reduce self-employment taxes reported on Schedule SE. Still, the benefits of the home-office deduction appear overstated on the 8829 in relation to their true benefit to the taxpayer who itemizes.

In addition, not all items relating to the home are includable for the home-office deduction. Although some home improvements may be includable, such as a new roof, other modifications may not. If an improvement is not related to the home office, such as new flooring in other spaces in the home, it is not deductible on the 8829. Improvements that are includable differ in terms of the way in which they are reported and the benefit. Items such as shelving specifically for the office space are fully 100 percent includable and, in fact, should be reported on Schedule C. Items that benefit the entire house, such as a new roof, are reported on 8829 but can only be included at the home office percentage.

The taxpayer needs to keep good records on a number of issues. Good documentation of the home's basis and any adjustments to the basis will need to be maintained. Information regarding qualification for the home-office deduction needs to be properly computed and retained by the taxpayer. This is especially true because returns utilizing the home office deduction tend to be audited at a higher rate.

Exhibit 1

Joe has incurred additional tax preparation fees during the years he utilized the home-office deduction for preparation of Form 8829. Additionally, upon the sale of his home, additional forms were required including Schedule D and Form 4797 (Sale of Business Property).
Years 1998-2001 Form 8829 ($30) $120
Form 4797 ($40) 40
Schedule D ($40) 40
Total additional estimated
tax preparation fees $200


However, other benefits of the home office deduction go beyond deducting expenses that would have been incurred anyway. For every dollar includable on the 8829, adjusted gross income (AGI) is lowered.

This may allow more medical and miscellaneous expenses to be deducted. And, for taxpayers who are unable to itemize, items such as home mortgage interest and real estate taxes become additional tax savings items. Further, the taxpayer whose residence is rented can include rental expense, which would not have been deductible for federal tax purposes.

Table I

Joe is a single taxpayer who has a home repair business that he runs out of his home. Utilizing the percentage of square footage method, 20% of his 1,500-square foot home qualifies for home-office purposes. The home was purchased for $200,000 in 1980. The fair market value of the land is $20,000. Joe began using the home office January 1, 1998. The table below presents information concerning the true benefit of the home-office deduction for tax year 2001, using three scenarios in terms of profitability of Joe's business.

Scenario I: Sufficient Schedule C income to fully utilize Form 8829 expenses.

Scenario II: Insufficient Schedule C income to utilize Form 8829 depreciation.

Scenario III: Insufficient Schedule C income to utilize Form 8829 expenses beyond line 12.

Potential Problems in Future Years

A word of caution is needed regarding the home-office deduction. Taking the deduction may end up costing the taxpayer in future years if the home is sold at a gain. The new rules for exclusion of gain on the sale of the taxpayer's principal residence have changed the relationship between these benefits.

Previously, when taxpayers depreciated their home when utilizing the home-office deduction, recapture rules applied, increasing the tax obligation upon sale. Under the old rules, when the home was sold, the gain was either recognized or deferred if the qualifying rules were met (IRC section 1034). An exclusion existed, but it was a one-time exclusion of $125,000 and the taxpayer had be 55 to qualify (IRS section 121). The old rule had the effect of keeping people in larger or more expensive homes for a longer period of time, so they could reach the age required for the exclusion.

The new rules, which exclude $250,000 gain for single and $500,000 gain for married taxpayers, relieve the burden on older taxpayers holding out for the one-time exclusion. In addition, the new rules allow the exclusion to be utilized more than once. However, it also impacts the benefit of the home-office deduction.

If a taxpayer sells a home in which he allocated a portion for home-office deduction purposes, he could end up paying taxes on some of the gain on the sale of the home, even if the total gain were below the exclusion amount. For example, if 20 percent of the taxpayer's home qualified for home-office deduction, 20 percent of the gain would be taxable, reported on Form 4797 (Part III) Sale of Business Property.

Some Good News, Some Not So Good News

The good news is that if the taxpayers meet the ownership and use tests for the entire house, they may claim the gain exclusion on the sale of their primary residence for both the home and business portions. (4) If the taxpayer did not use the portion of the home allocated for business for two of the last five years prior to sale, the use test is satisfied. Therefore, if the taxpayer ceases to use the home office for two years prior to the sale, the exclusion will apply to the former home-office portion and is reported on Form 4797, line 2. However, this takes careful planning and may not always be possible for the taxpayer. And, it does not eliminate all of the problems with the prior home-office deductions.

The taxpayer would also have to deal with the issue of depreciation. Any gain attributable to depreciable deductions after May 7, 1997, would be considered unrecaptured Section 1250 gain, which is not eligible for the exclusion and therefore taxable at a rate of 25 percent. It is included on Worksheet 2 in IRS publication 523, entitled "Selling Your Home," and is reported on Schedule D, line 19. And, as is true for many tax issues, marginal tax rates may have been different, beneficial or disadvantageous, in the tax years of the deduction compared to the year of the recapture.

Table II

Joe sells his home in 2001 for $350,000. Below are two scenarios illustrating the future tax implications.

Scenario I: Joe is able to meet the use test 2 of the last 5 years.

Scenario II: Joe is unable to meet the use test 2 of the last 5 years, all gain excluded.

Summary

Changes in the rules for deducting the home office have generated renewed interest in this deduction. Under certain circumstances, utilizing the home-office deduction is in the best interests of the client and provides an opportunity to deduct expenses generally regarded as personal in nature.

If the taxpayer's situation qualifies, and especially if the taxpayer is currently itemizing, it is likely that the home-office deduction will be beneficial. In other cases, the taxpayer may be better advised to forego the home-office deduction. By establishing a work area that does not qualify, such as the exclusive use test, office expenses for the self-employed taxpayer will still be deductible on Schedule C without invoking some of the problems with the home-office deduction.
Table I

 Scenario

 I II

Gross income from Schedule C business: $20,000 $13,736
Other expenses on Schedule C: 10,000 10,000

Gross income before home 10,000 3,736
office deductions

 Home office deduction:
 Mortgage interest ($11,200 X 20%) $2,240 $2,240
 Real estate taxes ($4,000 X 20%) 800 800
 Insurance ($600 x 20%) 120 120
 Utilities ($2,880 x 20%) 576 576
 Depreciation 923 carried over
 Total expenses on Form 8829 $4,659

Net Income reported on Schedule C $5,341 $0

Benefit as it appears on Form 8829 $4,659 $3,736

Benefit including depreciation, if allowed $1,619 $696

True benefit to Joe, excluding depreciation * $696 $696

 Scenario

 III

Gross income from Schedule C business: $11,000
Other expenses on Schedule C: 10,000

Gross income before home 1,000
office deductions

 Home office deduction:
 Mortgage interest ($11,200 X 20%) $2,240
 Real estate taxes ($4,000 X 20%) 800
 Insurance ($600 x 20%) carried over
 Utilities ($2,880 x 20%) carried over
 Depreciation carried over
 Total expenses on Form 8829

Net Income reported on Schedule C $0

Benefit as it appears on Form 8829 $3,040

Benefit including depreciation, if allowed $0

True benefit to Joe, excluding depreciation * $0

(* True benefit excludes depreciation because of recapture rules)

Table II

 Scenario

 I

 Personal Business
 (80%) (20%)

Selling price: $280,000 $70,000
Selling expenses (24,500) 19,600 4,900

Net $260,400 $65,100

Purchase price $160,000 $40,000
Depreciation 1998-2001 3,654
Adjusted basis 160,000 36,346

Gain 100,400 28,754

Depreciation after May 6, 1997 (all) 3,654
Net 100,400 25,100
Maximum exclusion $200,000 $50,000

Gain exclusion (lesser of net or maximum) 100,400 25,100

Taxable amounts:
Taxable gain (at 20%) 0 0
Unrecaptured Section 1250 gain (25%) 0 914

Tax impact 0 914

 Scenario

 II

 Business
 (20%)

Selling price: $70,000
Selling expenses (24,500) 4,900

Net $65,100

Purchase price $40,000
Depreciation 1998-2001 3,654
Adjusted basis 36,346

Gain 28,754

Depreciation after May 6, 1997 (all) 3,654
Net 25,100
Maximum exclusion $50,000

Gain exclusion (lesser of net or maximum) 0

Taxable amounts:
Taxable gain (at 20%) 5,020
Unrecaptured Section 1250 gain (25%) 914

Tax impact 5,934


End Notes

(1.) Daniel, Lee L., and Weld, Leonard. G. (2000/2001). The Expanded Home Office Deduction Rules Make it Easier for the Taxpayer to Qualify. National Public Accountant, December/January, 45(10), 52-55.

(2.) On-line, www.IRS.gov.

(4.) IRS publication 523, Selling Your Home.

(3.) Novak, Janet. (2001). The Informer. Forbes, May 01, 167(11), 30.

Donna Whitten, CPA, MBA, is Assistant Professor in the Business Department at Purdue University North Central, in Westville, IN.
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Author:Whitten, Donna
Publication:The National Public Accountant
Geographic Code:1USA
Date:Feb 1, 2003
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