Home | Videos From The Expert | Tax Tips | Meet Our Team | Newsletter | Helpful Calculators | Contact Us

		THE HOME OFFICE TEST By Joseph Pontrella - Tax Supervisor January 22nd, 2007
		Introductions Internal Revenue Code (IRC) Section 280A allows a taxpayer to deduct home office business expenses for a personal residence that would not otherwise be deductible providing certain criteria are met. To qualify for home office deductions, the portion of the residence that is used for business must be used exclusively on a regular bases (1) as the principle place of the taxpayer's trade or business; (2) a place of business which is used by patients, clients or customers who deal with the taxpayer's in the normal course of his trade or business; or (3) a separate structure not attached to the residence that is used in connection with the taxpayer's trade or business. The principle place of business requirement will be met if the home office is used for administrative or management activities if there is no other place where such activities are performed. Deductions Home office deductions are computed on Form 8829. Items qualifying for the deduction must be prorated between personal and business use. This is typically done by taking the square footage of the area used exclusively as an office divided by the overall square footage of the residence. Qualifying items include mortgage interest, real estate taxes, utilities, maintenance, insurance and depreciation. With the exception of the property taxes and mortgage interest, which are considered itemized deductions, the other items would normally be considered personal in nature and not deductible. Limitations The Internal Revenue Code prescibes a net income limitation for this deduction. The deduction is limited to gross income from the busines (1) deductions which would otherwise be allowable, such as mortgage interest and property taxes; and (2) all other deductions allocable to the business that are allocable to home office use, such as normal general and administrative expenses. In the event the business has a net loss, the portion of the home office deduction that has increased the loss must be carried forward to the following year subject to the same net income limitations. Other Issues An issue may arise with respect to mortgage interest and property taxes allocable to the business usage. When the taxpayer is self-employed, the business portion of such expenses will be deduction on Schedule C of Form 1040. This will always be more advantageous than deducting the same on Schedule A of Form 1040. On Schedule C, there is no standard deduction that must be exceeded before deductions become effective and there is no potential phase-out of certain deductions, including mortgage interest and property taxes, as provided by the IRC Section 68 for adjusted gross income that exceeds certain limits. For example, assume a self-employed married taxpayer who files a joint return has $6,000 of itemized deductions, $5,000 of which is mortgage interest and property taxes. None of these could be deducted on Schedule A for itemized deductions because they do not exceed the standard deduction amount for a married couple filing a joint return. However, if 40 perfect of the residence qualifies for the home office deduction, the taxpayer would be allowed to direct offset to business income of $2,000 on Schedule C ($5,000 x 40%). Even if the taxpayer has sufficient itemized deductions that exceed the standard deduction, the phase-out of IRC Section 68 may be applicable. However, once again, this is not an issue if any portion of the interest and property taxes can be allocated to the home office deduction. All such allocations will result in a direct reduction of income. Employees IRC Section 280A provides that employees who wish to take the office in home deduction must meet the convenience of the employer test. This generally means that the use of the home office is necessary to carry on the employer's business. It may, in certain circumstances, be more advantageous for an employee to simply forego the office in home deduction. Office in home deduction of an employee are a two percent miscellaneous itemized deduction of Schedule A and would also be subject to the adjusted gross income phase-out rules provided in IRC Section 62. This means it is quite possible that an employee would receive little or no benefit for such expenses. Mortgage interest and property taxes are direct itemized deductions on Schedule A and are not figured into the computation of the home office deduction of an employee. The employee who takes the home office deduction must also reduce the basis of the residence by the amount of depreciation allowable. This reduction will take place even if the actual benefit of the home office deduction is minial or, in some cases, nonexistent. IRC Section 121 Implications This section allows an exclusion gain up to $250,000 for a single taxpayer and $500,000 for taxpayers filing a joint return who sell their residence if it was owned and used by the taxpayer as a principle residence for two of the five years preceding the sale. The ownership and use tests do not need to occur simultaneously. Issues arise when part or all of the residence has been used as a home office. As already notced, IRC 121(d)(6) requires that the portion of the residence that has been depreciated is subject to a maximum recapture of 25 perfect of the gain even if it is subsequently converted to personal use. However, the regulations allow the exclusion to apply even to the part of the residence that is being used for the home office deduction. For example, a taxpayer, who is single and self-employed, has owned and used her principle residence for six years. During that time she has also used a home office on which she has taken $10,000 of depreciation deductions. The taxpayer's basis in the house is $200,000. The residence is sold for $500,000. The taxpayer will have a $10,000 gain recaptured on the depreciation at a maximum capital gain rate of 25 percent, $50,000 capital gain taxed at 15 perfect, and $250,000 of excluded gains. Note that in the above example it is not necessary for the taxpayer to convert the business portion of her residence to personal use in order to qualify for the exclusion on the part of the residence used as a home office. The regulations provivde a very liberal view on how to apply the exclusion. For example, in the above illustration, the regulations could have required that if the home office comprised of 25 percent of the total space of the residence, then that portion would not qualify for the exclusion. Instead, take the position that gain only applies to the depreciation taken. Conclusion The home office will normally be considered part of the residence for the purpose of the IRC Section 121 exclusion upon the sale of a residency. Therefore, home office deductions should always be used for self-employed taxpayers. The tax benefit for above the line deductions on a Schedule C will usually more than compensate for any potential recapture caused by the selling of the residence. Schedule C deductions have the potential to reduce income taxes at the highest rate as well as self employment taxes, while depreciation recapture is taxed at a maximum rate of 25 percent. However, since the recapture is considered a capital gain, it can be used to offset capital losses. This depreciation also allows Schedule C deductions for items allocable to the home office such as insurance, utilities and maintenace. A different result may occur for an employee. So in this case, it may be worthwhile to deliberately fail the requirement of IRC Section 280A. An issue may arise as to when the home office is considered a separate structure from the residence and thus does not qualify for the exclusion upon sale of the home. This can occur when there is more than one structure on the same property or certain types of separations exist in the same building. In such situations, careful tax planning is required, especially since hte IRS has indicated they are monitoring the area closely, and will randomly select returns for audit.