Web Exclusive: The Real Cost of the Home Office Tax Deduction
Not too surprising, many of those involved in the surveying and mapping fields that qualify for a home office deduction usually take full advantage of it. Keep in mind, however, under U.S. tax laws, the home office deduction reduces the amount of gain that can be ignored when your residence is eventually sold or exchanged.
Our tax law permits a tax deduction for the expenses associated with a home office so long as that office is exclusively used on a regular basis as the principal place of business for any surveyor. The IRS created a test in a 1994 Revenue Ruling for comparing the relative importance of the work done by the taxpayer at each location just to help determine his or her "principal place of business."
If that comparison did not clearly identify your principal place of business, the IRS would then compare the amount of time spent at each location. This IRS ruling opened up the door to many contractors, plumbers, electricians, salespersons and surveyors whose work was performed outside the home, allowing them to meet the test and deduct the expenses associated with a home office.
The Taxpayer Relief Act of 1997 further expanded the definition of a principal place of business. Today, an office located in the home qualifies as a principal place of business if:
- the office is used by a surveyor for the administrative or management activities of his or her business; and
- there is no other fixed location of that surveying business where the surveyor conducts substantial administrative activities.
Thus, as long as the home office is used by a surveyor for administrative or management activities and they do not conduct substantial administrative or management activities at another fixed location, it qualifies as a principal place of business and also qualifies for the associated tax deductions for home office expenses.
Although the home office deduction is limited to the gross income from that activity, few surveyors have been deterred from claiming a tax deduction for the portion of expenses such as home mortgage interest and property taxes, insurance, maintenance and utilities that are associated with the use of a home office. Even a depreciation allowance for the portion of the residence used as a home office can be deducted. This is one reason why many surveyors may wish to ignore the home office expense deduction.
The DownsideThe same tax law changes that opened up the home office deduction to more taxpayers (TRA '97), also expanded the amount of gain resulting from the sale of a residence that could be excluded from income or ignored by dropping the age 55 or older restrictions. Today, any taxpayer, regardless of age, may exclude from taxable income the first $250,000 ($500,000 for married couples filing joint returns) of gain from the sale or exchange of a principal residence. In order to qualify for this exclusion, however, the property must be owned and used by the taxpayer as a residence for periods aggregating two or more years during the five-year period ending on the date of sale.
Unfortunately, any surveyor who claims a home office deduction may not be able to exclude the entire amount of gain on the sale of his or her personal residence. First, under our tax rules, gain must be recognized to the extent of any depreciation deductions taken on a home office. Second, the entire portion of the home used as a home office is ineligible for exclusion if it isn't used as a principal residence for two-out-of-every-five years before the sale.
In the past, many surveyors avoided depreciation recapture or payback by shutting down the home office and using it as a residence before selling the home. Now, after TRA '97, the portion of gain attributable to depreciation must be recognized even if the entire residence is converted to personal use before the sale.
Fortunately, the required recognition of previously taken, or allowable, depreciation deductions shouldn't prevent you from claiming a home office deduction. Depreciation taken on a home office is, of course, deducted against ordinary, fully taxable income. For self-employed surveyors, the deduction is allowed when computing net earnings from self-employment, reducing both the amount of taxable income and the amount upon which those onerous self-employment taxes are computed.
Under U.S. tax rules, gain resulting from the recapture or payback of straight-line depreciation, the method required for most buildings and portions of buildings, is considered to be "unrecaptured" Section 1250 gain. That Section 1250 gain is, of course, subject to a maximum tax rate of 25 percent. Thus, that recaptured depreciation, Section 1250 gain, is taxed at a rate of only 25 percent while today's depreciation deductions may offset income that is taxed at a 28 percent rate.
An Unquestionable PitfallThe most serious problem for those surveyors claiming both a home office deduction and an exclusion of gain on the sale of a principal residence arises because of that "two-out-of-five-year" use requirement. Any portion of the home used exclusively as a home office cannot, at the same time, be used as a principal residence.
As a result, if a portion of the home is used as a home office for more than three years in the five-year period ending on the date of sale, the two-out-of-five-year use requirement is considered "not met" for that part of the house. The entire amount of gain attributable to that part of the house, not just depreciation, must be included in income.
Tax Strategy Equals SavingsMany surveyors may want to forego the home office deduction entirely. This strategy is particularly advisable for surveyors with relatively few home office expenses and with a large, built-in gain on a principal residence that they are certain that they will sell in the near future. The tax savings from claiming a home office deduction may not be sufficient to offset the loss of part of the home sale proceeds exclusion (Section 121).
Of course, taking full advantage of the home office deduction is still advisable for some surveyors, even if they are contemplating selling their principal residence. Anyone with a large amount of home office expenses may be better off taking an immediate deduction, even though they have to recognize that gain in the future. The savings in self-employment taxes alone may make the immediate deduction of home office expenses the most advisable course of action. The continued deduction of home office expenses is usually advisable if the expected gain on the sale of the home is small.
A "two on and three off" strategy involves using the office for personal purposes, thus disqualifying it as a principal place of business, for two years followed by using it exclusively as a home office in three years. This strategy will ensure that the portion of a principal residence used as a home office will always qualify for gain exclusion.
The price of ensuring that the two-out-of-five year use requirement is met and the entire home qualifies as a principal residence at all times is the loss of a home office deduction two-out-of-every-five years. This "cost" may be advisable for surveyors with large built-in gain on their residence who contemplate a sale of the residence at some point in the future but who may be unsure of the timing of the sale.
Obviously, the "two on and three off" strategy should not be used by surveyors who has no intention of selling their principal residence in the foreseeable future. Those surveyors should continue to take full advantage of the home office deduction. If they are forced to change their principal residence because of a change in employment or health, that two-year use requirement does not apply.
Benefiting from Ignoring a Tax DeductionBy now it should be obvious that there is more than one side to the income tax deductions for home office expenses. Proper planning should consider more than the impact that those deductions will have on this year's tax bill.
Taking full advantage of the home office deduction may also still be advisable for other surveyors, even if they are contemplating selling their principal residence. Those surveyors with a large amount of home office expenses may, for instance, be better off taking an immediate deduction even though they have to recognize gain in the future.
The saving of self-employment taxes alone may make the immediate deduction of home office expenses your most advisable course of action. Unfortunately, no surveyor can possibly predict whether they will benefit more from an immediate deduction for home office expenses or from abandoning that deduction, even for a minimum of two years in every five-year period. So, despite all of the variables and all of the uncertainty surrounding your own home sale plans, the home office expense deductions warrant thinking about both the positive and negative outcomes.
Sidebar: An Often Overlooked Home Office BenefitIn a 1999 Revenue Ruling the IRS concluded that if a surveyor's residence qualified as a principal place of business, the daily transportation expenses incurred in going between the residence and another work location in that same trade or business would be tax deductible. Naturally, if the residence doesn't qualify as a principal place of business, the IRS considers those expenses to be nondeductible commuting expenses.
A surveyor risks losing some deductible transportation expenses by foregoing a home office deduction. That can mean the cost of going from the residence to the first business location of the day and from the last business location of the day back to the residence. Naturally, transportation between business locations is deductible regardless of whether the residence qualifies as a principal place of business.
Although there is some legal basis for the position that transportation costs may be deductible even if the residence doesn't qualify as a principal place of business, the IRS has made it clear that a surveyor can expect an IRS challenge to any deduction of transportation expenses between the residence and the first business location of the day.
Obviously, any surveyor with a significant amount of transportation expenses should include this factor in any analysis undertaken to determine whether they should forego a home office deduction because of the contemplated sale of a principal residence.