The Ticking Time-Bomb of The Home Office Deduction

  
The starting point for this discussion assumes that you the reader are familiar with the basics in terms of qualifying for the home office deduction. Let’s assume you have met the place of business test and the regular and exclusive use test. Let’s assume that, should you be questioned, you have evidence of actual office facilities….desk, files, a phone, record of work done, storage and inventory use, and business visitors, if clients come to your office.

Let’s assume that the deduction is worthwhile taking, that benefit outweighs the extra cost of preparing the Form 8829 Expenses for Business Use of Your Home for sole proprietors, or Form 2106 Employee Business Expenses, in case of an employee. It can take as much as an hour to fill out the form initially, and perhaps a quarter to half hour of  extra time after the first year.
 
Computing The Tax Benefit

It is not always clear to the uninitiated how to compute the benefit. It must be kept in mind that in adding up the deductions, interest and real estate taxes should not be added in. Why? Because those deductions are already fully allowed in Schedule A, and they will be fully allowable if they are part of a home office deduction in Form 8829. What really counts is all the other costs. The other costs are home owner’s insurance, repairs, utilities, and cleaning (lawn care and snow removal may be a little aggressive). To compute the benefit, multiply the total of other costs times the percentage of space used for business. Then multiply that amount by your marginal tax rates for federal and state. The result is your permanent tax savings. Depreciation will be discussed below.

Employees trying to claim a home office deduction have a couple of hurdles to overcome in order to nail down tax benefits. First, an employee must show that the business use of the home is for the convenience of the employer. That is extremely difficult. The Cadwallader case is the reliable case law for employees. Professor Cadwallader claimed a home deduction in his Schedule A (a red flag) even though the psychology department gave him exclusive use of two offices at the college. The Tax Court denied the deduction and the Seventh Circuit of Appeals affirmed. The second hurdle is the Miscellaneous Itemized Deduction 2% threshold which a taxpayer has to exceed in order to get an effective deduction. If there are little or no other miscellaneous itemized deductions, the employee may be losing some portion of his interest and real estate taxes which he would otherwise be entitled to.
 
Depreciation

Depreciation is the deduction allowed for use of the home in a business. It is computed by spreading the cost of the structure (not the land) plus improvements over a 39 year period. The 39 year period is the tax table life for nonresidential buildings, and that is, in essence, what the space represented by the home office is, says the IRS. It is commercial space.

Depreciation reduces the cost basis of the home so that upon sale, the gain must be computed using the cost reduced by depreciation. A taxpayer has no choice but to reduce the basis, even if the taxpayer decides not to take the depreciation deduction, for whatever reasons. The IRS says it is allowable, meaning basis must be reduced. Therefore, depreciation is not a permanent deduction. The tax code takes it back, if any part of the gain becomes taxable at some point in the future.
 
The Timebomb

Under Section 121 gain on sale of a residence is excluded from taxation if: 1) the gain is less than the allowable exclusion, and 2) the taxpayer owned and used the residence as a principal residence for 2 out of the last 5 years. Allowable exclusions are $250,000 for a single taxpayer and $500,000 for married filing joint taxpayers. Any gain above those exclusions is taxed.

The timebomb is the 2-out-of-5 year rule. If a taxpayer had a home office in either of the two years prior to a sale of the residence, that portion of the home is not a principal residence. Therefore, it is taxed as a capital gain. Watch out for this trap!! In order to avoid taxation, the home must be used as a residence at least 730 days out of five years, not two tax years.

So, that doesn’t seem so bad if the taxpayer was in say a 28% tax bracket or higher, right?? If the home was held more than one year, the capital gain rate would be 20%, or if held more than five years and acquired after 2001, the rate would be 18%! Well, unfortunately, gains on sales of rental or business real estate carry a 25% rate to the extent of depreciation taken after May 6, 1997, and 20% on the balance of any gain, subject to qualifying for the new 18% rate.

You think that’s not so bad if a taxpayer is and has been in a 35% or 38.5% bracket. The problem is how long has the taxpayer deducted the home office and has there been enough years to more than make up for the cash out of pocket that a capital gain tax may take.

Let’s look at an example

Joel and his wife, ages 61 and 60, have lived in their home for 30 years.

Joel runs a successful business as an author from his home. Their home is valued at $600,000 and they paid $50,000 for it in 1971. Joel uses 10% of his home for business and has always claimed a home office deduction and depreciation in an amount of $4,000 of which $500 is post May 6, 1997 depreciation.  If Joel and his wife were to sell the home today, the gain would be $556,000 but they would have to report as taxable gain $59,000, which is 10% of the sale price less 10% of the cost minus $4,000 of depreciation. The $500 would be taxed at a 25% rate and the balance of gain, $58,500, would be taxed at a 20% rate. There would be no Massachusetts tax because the asset was held more than six years.

Because Joel deducted the home office over 30 years, he has probably saved more than the $11,825 in capital gain taxes. Most homeowners don’t live in a single home more than five years on average, however. Therefore, the home office deduction should be approached carefully.
 
The Business Use Definition-A Trap

 The instructions to From 2119 Sale of A Home say that if the taxpayer is not entitled to deduct expenses related to the business use of a home, the entire sale is reported on Form 2119. Code Section 121 talks about ownership and use. Nothing is said about the deduction of a home office per se. Therefore, it is conceivable that a taxpayer could be using an office at home, never having claimed a deduction for it, and still be caught be the statutory language of the Code and instructions to Form 2119.

The way to avoid this trap is to deliberately fail the regular and exclusive use test by having some personal use of the home office space. That could be storing personal items in the space. It could be having personal computer programs on the PC and using them in the home office space. It could be having a party and using the home office space.

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This tax change letter is being published on our website and issued to clients with the understanding that we are attempting to provide information only. We are not providing tax or financial advice with respect to any given individual situation. Our services or the services of a competent tax or financial planning practitioner should be sought for the purpose of applying this information to specific situations.