Because a personal residence is a personal use asset, utility payments and depreciation due to wear and tear are not deductible expenses. However, self-employed taxpayers (not employees) who use their home—or at least part of their home—for business purposes may be able to deduct expenses associated with their home use if they meet certain stringent requirements.27
To qualify for home office deductions, a taxpayer must use her home—or part of her home—exclusively and regularly as either
1. The principal place of business for any of the taxpayer’s trade or businesses, or 2. As a place to meet with patients, clients, or customers in the normal course of business.
LO 14-6
Example 14-14
Suppose the Jeffersons incurred a $12,939 passive loss from their Scottsdale rental home (as de- scribed in Example 14-13), and they did not receive any passive income during the year. Assuming that their current-year AGI is $250,000 and they are considered to be active participants in the rental activity, how much of the rental loss are the Jeffersons allowed to deduct this year under the rental real estate exception to the passive activity loss rules?
Answer: $0. Because their adjusted gross income exceeds $150,000, the $25,000 deduction excep- tion to the passive activity loss rules is completely phased out. Consequently, the Jeffersons are not allowed to deduct any of the $12,939 rental loss for the year.
What if: How much of the $12,939 loss could the Jeffersons deduct for the year if their adjusted gross income (before considering the rental loss) were $120,000?
Answer: In this case, they could deduct the entire $12,939 loss. The $25,000 exception amount would be reduced by a $10,000 phase-out [50 cents × ($120,000 − $100,000)]. The maximum amount of the rental loss that can offset ordinary income would therefore be reduced from $25,000 to
$15,000 ($25,000 − $10,000 phased out). However, because their loss is less than $15,000, they may deduct the entire $12,939 rental loss against their other sources of income for the year.
25Recall that second homes falling into the significant-personal-and-rental-use category are not passive activities. See §469(j).
26§469(i).
27§280A. If taxpayers rent the home they occupy and they meet the requirements for business use of the home, they can deduct part of the rent they pay. To determine the amount of the deduction, multiply the rental payment by the percentage of the home used for business purposes.
be a passive activity.25 Because they are passive losses, losses from rental properties are generally not allowed to offset other ordinary or investment type income. However, as we also discussed the Investments chapter, a taxpayer who is an active participant in a rental activity may be allowed to deduct up to $25,000 of the rental loss against nonpassive income.26 Consistent with a number of tax benefits, the exception amount for active owners is phased out as adjusted gross income increases: The $25,000 maximum exception amount is phased out by 50 cents for every dollar the taxpayer’s adjusted gross income (before considering the rental loss) exceeds $100,000. Consequently, the entire
$25,000 is phased out when the taxpayer’s adjusted gross income reaches $150,000.
The taxpayer is not required to meet the exclusive use test in order to claim the home office deduction if the taxpayer either
∙ Uses part of the home for the storage of inventory or product samples.
∙ Uses part of the home as a day care facility.
When a taxpayer has more than one business location, including the home, which is the taxpayer’s principal place of business? This is a facts-and-circumstances determination based upon
∙ The relative importance of the activities performed at each place where the taxpayer conducts business (more income from an activity generally means it is a more im- portant activity) and
∙ The total time spent doing work at each location.
However, by definition, a taxpayer’s principal place of business also includes the place of business used by the taxpayer for the administrative or management activities of the tax- payer’s trade or business, if there is no other fixed location of the trade or business where the taxpayer conducts substantial administrative or management activities of the trade or business.28
If a taxpayer meets with clients or patients in her home during the normal course of business, she qualifies for the home office deduction even if the home is not her principal place of business. However, the clients or patients must visit the taxpayer’s home in person.
Communication through telephone calls or other types of communication technology does not qualify.
28§280A(c)(1).
What if: Jasmine recently quit her job as an employee for an advertising firm because, with the move to the new home, the commute was too long. She has decided to go it alone as a self-em- ployed graphic designer. She uses a large room in the basement of the Jeffersons’ new home as her office. The room has been wired for all her office needs. The Jeffersons use the room exclu- sively for Jasmine’s graphic design business use. Does this space qualify for the home office deduction?
Answer: Yes. While Jasmine will spend a good deal of time meeting with clients outside her home office, she has no other fixed location for her trade or business. Further, the office is used exclusively for business purposes. Consequently, the office qualifies for the home office deduction subject to certain limitations described below.
Example 14-16
What if: Jasmine recently quit her job as an employee for an advertising firm because, with the move to the new home, the commute was too long. She has decided to go it alone as a self-employed graphic designer. She uses a large room in the basement of the Jeffersons’ new home as her office.
The room has been wired for all her office needs. Once or twice a week, Tyler sits at the desk in the room and surfs the Web to read up on his favorite sports teams. Is the office space eligible for a home office deduction?
Answer: No. The office is not used exclusively for Jasmine’s business. Tyler’s personal use of the office disqualifies the office for the home office deduction.
Example 14-15
Taxpayers fail the exclusive use test if they use the area of the home in question for any personal purpose.
THE KEY FACTS Home Office Deduction
• Deductibility limits on expenses allocated to home office
• The expenses are deducted for AGI but deductions may be sub- ject to income limitation.
• If deduction is limited by income limitation, apply the same tiered system used for rental property when tier 2 and tier 3 deductions are limited to gross rental income mi- nus tier 1 expenses.
• Taxpayers can elect the simplified method to report home office expenses.
• Deduct allowable busi- ness use square footage (limited to 300 sq. feet)
× $5 per square foot.
• Deduction limited to gross business revenue (minus business ex- penses unrelated to home).
• No carryover of excess deduction to subsequent year.
• Deduct all property taxes and mortgage interest as itemized deductions.
• Do not deduct deprecia- tion expense so basis in home is unaffected by home office expense deduction (under the simplified method).
• Depreciation expense
• Reduces basis in home.
• Gain on sale due to de- preciation deductions after 5/6/1997 is ineli- gible for exclusion.
• This gain is taxed at a maximum 25 percent rate as unrecaptured
§1250 gain.
Direct versus Indirect Expenses
When taxpayers qualify for home office deductions, they are allowed to deduct only ac- tual expenses that are related—either directly or indirectly—to their business. Direct ex- penses are expenses incurred in maintaining the room or part of the home that is set aside for business use. They include painting or costs of other repairs to the area.29 These ex- penses are deductible in full as home office expenses. Indirect expenses are expenses in- curred in maintaining and using the entire home. Indirect expenses include insurance, utilities, interest, real property taxes, general repairs, and depreciation on the home as if it were used entirely for business purposes. Depreciation on the home is calculated using nonresidential real property depreciation tables (straight-line depreciation over 39 years).
In contrast to direct expenses that are fully deductible, only indirect expenses allocated to the home office space are deductible.
How do taxpayers allocate indirect expenses to the home office space? If the rooms in the home are roughly of equal size, the taxpayer may allocate the indirect expenses to the business portion of the home based on the number of rooms. In a 10-room home, a taxpayer using one room for qualifying business use is allowed to deduct 10 percent of the indirect expenses. Or the taxpayer may allocate indirect expenses based on the square footage of the business-use room relative to the total square footage in the home. If the home is 5,000 square feet and the home office is 250 square feet, the taxpayer may deduct 5 percent of the indirect expenses. Unrelated expenses such as painting a room not used for business purposes are not deductible.
In lieu of allocating actual expenses to home office use, the IRS allows taxpayers to use an optional simplified method for computing home office expenses.30 Under the sim- plified method, taxpayers are not allowed to deduct any actual expenses relating to quali- fied business use of the home (including depreciation). Instead, taxpayers electing the simplified method deduct, subject to limitations described below, the allowable business use square footage of the office (not to exceed 300 square feet) multiplied by $5 per square foot. Thus, this method generates a maximum deduction of $1,500 (300 square feet × $5 per square foot). In addition, taxpayers using this method are allowed to deduct all of their home mortgage interest and real property taxes as itemized deductions on Schedule A. Taxpayers may choose from year to year whether to use the simplified method or the actual expense method.
TAXES IN THE REAL WORLD If You Want The Bathroom to Qualify as a Part of a Home Office, You Better Lock It and Keep the Key
The IRS and a taxpayer with seven years of IRS work experience have battled over home office expenses in the Tax Court. The taxpayer oper- ated an accounting business, and he used a bed- room in his residence exclusively for his accounting business. The taxpayer included the bathroom adjacent to the bedroom in his home office square footage. However, because the tax- payer testified that his children and personal
guests occasionally used the bathroom, the Tax Court determined that the bathroom was not used exclusively for business purposes (the chil- dren and personal guests may beg to differ), and it disallowed the expenses associated with the bathroom square footage. See Luis Bulas, T.C.
Memo. 2011-201 (2011).
Source: Luis Bulas, T.C. Memo. 2011-201 (2011).
29The basic local telephone service charge, including taxes, for the first telephone line into a home is a nondeductible personal expense. However, charges for business long-distance phone calls on that line, as well as the cost of a second line into the home used exclusively for business, are deductible business expenses. However, these expenses are not deducted as home office expenses. Rather, these expenses are deducted separately on the appropriate form or schedule. Taxpayers filing Schedule C (Form 1040) would deduct these expenses as utilities.
30Rev. Proc. 2013-13.
The Jeffersons moved into their new $800,000, 6,000-square-foot home on February 1 (the home building was valued at $600,000, and the land was valued at $200,000.) Jasmine quit her job and set up a 420-square-foot home office in the basement on that same date. Through the end of the calendar year, the Jeffersons incurred several expenses relating to their home (see table below). Assuming they qualify for the home office deduction, they would sum the direct expenses and the indirect expenses allocated to the office. They would allocate the indirect expenses based on the square footage of the office compared to the rest of the home. Using the actual expense method, what amount of home- related expenses would qualify as home office expenses?
Answer: $4,575. See allocation below. All direct expenses and 7 percent of the indirect expenses would be allocated to the home office (420 office square footage/6,000 home square footage). The Jeffersons would allocate the expenses as follows:
Total (A) (B) (A) × (B)
Expense Type Amount Office % Home Office Expense
Painting office Direct $ 200 100% $ 200
Real property taxes Indirect 11,000 7 770
Home interest expense Indirect 27,917 7 1,954
Electricity Indirect 2,600 7 182
Gas and other utilities Indirect 2,500 7 175
Homeowner’s insurance Indirect 5,000 7 350
Depreciation Indirect 13,482 7 944
Total expenses $62,699 $4,575
The expenses attributable to the home office are deductible subject to the limitations discussed below. Also, as discussed below, the Jeffersons are able to deduct the home interest expense not allocated to the home office as an itemized deduction.
What if: Suppose Jasmine elects to use the simplified method for determining home office expenses.
What would be the amount of their home office expenses?
Answer: $1,500 (300 square feet × $5 per square foot). Even though the Jeffersons’ home office is 420 square feet, for purposes of the home office expense under the simplified method, the square footage is limited to 300 square feet.
What if: Suppose the Jeffersons elect to use the simplified method for home office expenses. What amount of home mortgage interest expenses and real property taxes would they be able to deduct on Schedule A as itemized deductions?
Answer: Home mortgage interest expense, $27,917; $11,000 of real property taxes before consider- ing the $10,000 itemized deduction limit on taxes. The Jeffersons also paid $15,000 in state income taxes. Consequently, of the total $26,000 they paid in taxes, they can deduct $10,000 as an itemized deduction.
Example 14-17
Limitations on Deductibility of Expenses
The process for determining the home office expense deduction using the actual expense method is similar to the process used to determine deductions for vacation homes. When net business income (net Schedule C income) before the home office deduction exceeds total home office expenses (before applying any limitations), the full amount of the ex- penses is deductible. However, when home office expenses exceed net Schedule C income (before the home office deduction), the deduction is potentially limited.
In these situations, taxpayers first divide home office expenses into one of three catego- ries or tiers. Tier 1 expenses consist of mortgage interest and real property taxes allocated to the business use of the home. Tier 2 expenses consist of all other expenses allocated to the business use of the home except depreciation. Tier 3 expense consists of depreciation.
Taxpayers first deduct tier 1 expenses in full, even when they exceed net Schedule C income before the home office deduction.31 Second, taxpayers deduct tier 2 expenses.
31§280A(c)(5).
However, deductible tier 2 expenses are limited to net Schedule C income before home office deductions minus tier 1 expenses (that is, deducting tier 2 expenses cannot create a net Schedule C loss). Any tier 2 expenses not deductible due to the income limitation are suspended and carried forward to the next year, subject to the same limitations. Finally, taxpayers deduct tier 3 expenses. The deductible tier 3 expense is limited to net Schedule C income before the home office deduction minus tier 1 and deductible tier 2 expenses (tier 3 expense cannot create a net Schedule C loss). The nondeductible portion of tier 3 expense is carried forward to the next year, subject to the same limitations.
Under the simplified method, the expense, as calculated by multiplying the square footage by the $5 application rate, is limited to net Schedule C income before home of- fice deductions. Further, taxpayers using the simplified method in a particular year may not carry over expenses disallowed by the income limitation and they may not deduct expenses carried over to that year under the actual expense method. However, disal- lowed expenses under the actual expense method can be carried over to a subsequent year in which the taxpayer uses the actual expense method for determining the home office expense deduction.
For the year, Jasmine generated $4,000 of net business income before the home office deduction from her graphic design business. Her home office expenses before limitation total $4,575 (see Example 14-17). The expenses consist of painting the office $200, real property taxes $770, home interest expense $1,954, electricity $182, gas and other utilities $175, homeowner’s insurance $350, and depreciation $944. What is the total amount of tier 1, tier 2, and tier 3 expenses?
Answer: Tier 1 expenses are $2,724 (real property taxes $770 and home interest expense of
$1,954); tier 2 expenses are $907 (painting office $200, electricity $182, gas and other utilities $175, and homeowner’s insurance $350); and tier 3 expense is $944 (depreciation).
What is Jasmine’s net income from the business after claiming the home office deduction and what expenses, if any, will she carry over to next year?
Answer: $0 net income, as shown in the table below. She will carry over $575 of depreciation expense.
Net Income from Business
Gross business receipts $4,000
Less tier 1 expenses (2,724)
Income after tier 1 expenses 1,276
Less tier 2 expenses (907)
Income after tier 2 expenses 369
Less tier 3 expenses (369)
Taxable business income $ 0
Due to the income limitation, Jasmine is allowed to deduct only $369 of the $944 depreciation ex- pense. She will carry over the remaining $575 ($944 minus $369) to next year to deduct as a home office expense (tier 3) subject to the same limitations.
What if: Suppose Jasmine uses the simplified method of determining home office expenses. What amount of the $1,500 expense (300 square feet × $5 application rate) will she be allowed to deduct?
Answer: She can deduct all $1,500, because the home office expense is less than the $4,000 net business income before the home office deduction.
What if: Assume the same facts as in the previous what-if scenario except that net business income before the home office deduction is now $1,200. What amount of the $1,500 home office expense will Jasmine be allowed to deduct?
Answer: $1,200. The home office expense deduction under the simplified method is limited to net business income before the home office deduction. Jasmine is not allowed to carry over the $300 nondeductible portion of the expense to a subsequent year ($1,500 total expense minus $1,200 deductible expense).
Example 14-18
When a taxpayer deducts depreciation as a home office expense, the depreciation expense reduces the basis of the taxpayer’s home. Consequently, when the taxpayer sells the home, the gain on the sale will be greater than it would have been had the taxpayer not deducted depreciation expense. Further, the gain on the sale of the home attributable to depreciation deductions (incurred after 5/6/1997) is not eligible to be excluded under the home sale exclusion provision. Rather, the gain is treated as unrecaptured §1250 gain and is subject to a maximum 25 percent tax rate (see the Property Dispositions chapter for a detailed discussion of unrecaptured §1250 gain).
At the beginning of the year, the Jeffersons’ basis in their home was $800,000. Jasmine’s first-year home office deductions included $369 in depreciation expense. What is the Jeffersons’ adjusted basis in the home at the end of the year?
Answer: $799,631 ($800,000 minus $369 deductible depreciation expense).
What if: Now suppose that the Jeffersons meet the ownership and use tests for the home sale exclu- sion and they sell the home for $900,000. Assume the only depreciation expense the Jeffersons have deducted is the $369 they deducted in the year they bought the home. Consequently, their adjusted basis in the home on the date of sale is $799,631 and they realize a gain of $100,369 on the sale.
How much of the gain, if any, must they recognize on the sale?
Answer: $369. They can exclude $100,000 of gain. However, they are not allowed to exclude the remaining $369 gain caused by the depreciation expense for the home office. The Jeffersons must pay $92 of tax on the gain ($369 × 25% unrecaptured §1250 gain).
Example 14-19
Taxpayers using the simplified method for deducting home office expenses are not allowed to deduct depreciation expense. Consequently, the simplified method does not affect the taxpayer’s adjusted basis in the home. However, if a taxpayer switches from the simplified method in one year to the actual expense method in a subsequent year, the taxpayer is required to use modified depreciation tables to compute depreciation expense under the actual expense method.
Allowing taxpayers to deduct part of their home-related expenses as business ex- penses creates temptations for taxpayers to deduct home-related expenses that don’t meet the deduction requirements. Not surprisingly, the IRS is very concerned about tax- payers inappropriately deducting expenses relating to their home. Consequently, ex- penses for business use of the home are some of the most highly scrutinized deductions available to taxpayers. Self-employed taxpayers claiming home office deductions must file a Form 8829 “Expenses for Business Use of Your Home” when deducting home of- fice expenses on a tax return. With the high level of scrutiny applied to home office ex- penses, taxpayers should be sure to have documentation available to support their deductions. Exhibit 14-7 includes Form 8829 for Jasmine based on the information in Examples 14-17 and 14-18.
CONCLUSION
When deciding whether to invest in a home as a primary residence, a vacation home, or even a rental home, prospective owners should consider both nontax and tax factors relat- ing to the ownership of the property. The tax code includes several provisions favorable to homeowners. This chapter is intended to provide current and prospective homeowners with enough insight on tax and nontax consequences of home ownership to allow them to make informed investment and compliance decisions when applicable.