Home Office Deduction

Posted on August 11, 2008 
Filed Under Deductions, Federal Income Tax | Leave a Comment

Generally speaking, deductions are not allowed for the business use of a personal residence, but Section 280A of the Internal Revenue Code permits a deduction for costs allocable to the portion of a home used as (1) the principal location of a trade or business or (2) the primary fixed location where administrative and management functions associated with a trade or business are performed. Expenses for the business use of a taxpayer’s home are listed on IRS Form 8829 (visit my Tax Forms page on the navigation menu above to see a copy of Form 8829 and instructions for this form under the “2007 Tax Forms” heading). Although managing an investment portfolio is an income-producing activity, it is not considered by the courts to be a business activity. (Translation: The cost of using a home office to manage an investment portfolio will not be included on any list of allowable unless the individual claiming the deduction is a professional trader or dealer in securities.)

Unfortunately, the home office cannot double as a nursery or recreation room. To qualify for the deduction, the portion of the dwelling unit or separate structure designated as the home office must be used exclusively and regularly for the taxpayer’s trade or business or related administrative and management activities. However, office space in the home doubling either as storage space for inventory and product samples or personal space in the case of a properly licensed daycare facility will not disqualify the home office as a principal place of business. Home office space can be used for more than one business activity and still qualify for a deduction provided all activities satisfy either the business or administrative use tests (see below). But if one of the uses doesn’t meet the convenience of the employer test (i.e., the use is not a direct and required part of the employee’s job), it fails the exclusive use test (an essential element of both the business and administrative use tests) thereby spoiling the deductibility of all other conforming business activities.

Changes to the Internal Revenue Code in 1976 restricted the scope of the home office deduction to a “dwelling unit exclusively used on a regular basis…as the principal place of business for any trade or business of the taxpayer” [Section 280A(c)(1)]. But with the Tax Reconciliation Act of 1997, Congress broadened the phrase “principal place of business” to include “a place of business which is used by the taxpayer for the administrative or management activities of any trade or business of the taxpayer if there is no other fixed location of such trade or business where the taxpayer conducts substantial administrative or management activities of such trade or business.” By virtue of the Tax Reconciliation Act of 1997, a self-employed taxpayer or employee using a home office for administrative and management activities and meeting the convenience of the employer test can do in 1999 and beyond (effective date of changes to Section 280A under the Act is December 31, 1998) what Congress tried to foil in 1976, namely, take a deduction for home office expenses. While occasional or incidental business use of a home office would fail the so-called business use test, a taxpayer regularly using a portion of his or her dwelling unit or separate structure for administrative or management activities, activities arguably incidental and occasional in character (a self-employed plumber, for example, is not in the business of doing things “administrative”), would be eligible for the home office deduction (in other words, taxpayer would pass the administrative use test).

Some generalizations are in order. First, the home office deduction cannot exceed the gross income from the related business activity, where gross income is reduced by home expenses that would be deductible anyway (e.g., , property taxes, etc.) and business expenses not directly connected to the home office (to illustrate, advertising, car and truck expenses, office supplies, salespersons’ expenses, wages and salaries) but deductible elsewhere. The point of subtracting these amounts from gross income is to prevent the taxpayer from deducting expenses twice. Home office expenses are deducted in the following order:

  1. The portion of indirect expenses (costs benefiting the entire household) allocable to the home office (see list of “indirect expenses” below); and
  2. Depreciation attributable to the home office.

Items (1) and (2) above cannot create a loss although they can be carried forward indefinitely.

Second, to pass the business use test, the home office must be used regularly and exclusively in at least one of the following capacities listed below. (Note: Use that is only incidental and occasional will fail the exclusive use test, causing the taxpayer to fail both the business and administrative use tests.)

  1. As the principal place of business;
  2. As a place to meet with clients or customers in the ordinary course of business;
  3. As a place to perform administrative or management duties required by taxpayer’s employer provided taxpayer has no other place to perform such duties, with the proviso that although deductible, employee home office costs are listed by the IRS as one of many miscellaneous itemized subject to a 2% of adjusted gross income (AGI) floor; or
  4. As a separate structure not attached to the dwelling unit that has a credible and proximate relation to the business (for instance, artist’s studio, greenhouse for a floral shop, shed used as bookbinding shop, etc.).

To pass the convenience of the employer test, a home office must be established on the basis of an employer’s need and in response to the fact that the employee has no other place to perform required administrative and management duties.

Third, a home office will pass the administrative use test if it meets two conditions:

  1. The office is used regularly and exclusively for administrative and management functions of the trade or business (common administrative and management functions include billing customers, keeping books and records of the business, making appointments, ordering supplies, and writing sales reports, among others); and
  2. There is no other fixed location where the taxpayer performs these functions.

A taxpayer who performs administrative and management functions at locations other than the home office will not be prevented from taking a deduction under the following circumstances:

Fourth, a home office can be depreciated, but depreciation is limited to the business use percentage of the home (viz., the area used exclusively as a home office divided by the total area of the dwelling unit). Any depreciation taken after May 7, 1997 may be subject to recapture upon sale of home. Put differently, even though a married taxpayer filing jointly can exclude from income up to $500,000 of gain on sale of a principal residence (the exclusion is $250,000 if married filing separately), he or she must recognize gain to the extent of home office depreciation that is, or could be, taken after May 7, 1997; click on for more information. The depreciable basis of a home office is the lesser of the cost or fair market value of the portion of the dwelling unit devoted to business use. The depreciable life (cost recovery period) of a home office is 39 years and starts on the date the office is first used for business. Since land is by definition a non-wasting asset with no determinable useful life, it is not included as part of the home office’s depreciable basis.

Fifth, the portion of indirect expenses related, and allocable, to the dwelling unit’s office space can also be deducted:

Finally, with the exception of capital expenditures (cost outlays that improve or extend the useful life of the property), direct expenses of keeping the home office functional are 100% deductible, including the cost of a separate phone line dedicated to business use.

For those worried about tax expenditures (shorthand for the idea that to maintain a given, and expected, level of public services, a polity must increase federal spending in order to make up for any reduction in revenue intake by reason of tax breaks), the more liberal rules for the home office deduction are a vexation. But for the self-employed or employees eligible for the home office deduction, these rules are the means to considerable tax savings, making it possible to (1) convert the nondeductible personal expenses of maintaining a residence into deductible business expenses, (2) reclassify Schedule A itemized deductions (some of which are subject to a 2% AGI floor) as Schedule C business deductions, and (3) re-christen previously nondeductible personal commuting expenses as deductible business expenses since the taxpayer is now traveling between his or her principal place of business (home office) and another work location in the same trade or business, even if the other work site is temporary and regardless of distance. Click on to see why having an office at home can provide the taxpayer with an auto expense bonus, that is, make commuting expenses deductible.

For more information on the home office deduction, consult the list of relevant articles below:

Many happy returns, Roger

Investment Interest Deduction

Posted on August 5, 2008 
Filed Under Deductions, Federal Income Tax | Leave a Comment

The Tax Reform Act of 1986 put a chill on many individual investors by enacting what is informally known as the “investment interest limitation,” in other words, limiting the deduction for interest paid to purchase or hold investments (including interest on margin accounts) to the amount of net investment income from such investments. Investment interest expense (abbreviated in this article as investment interest) is one of the itemized deductions not subject to phase out for high income taxpayers. If investment interest exceeds net investment income, it can be carried forward indefinitely.

Investment interest is defined as interest paid on debt to buy or carry investment property. Investment interest to buy or carry tax-exempt securities (e.g., municipal bonds) or other tax-free investments is not deductible. On the whole, investment interest does not include interest related to passive activities, , or capitalized construction period interest.

Investment property comprises the following:

  1. Property such as stocks, bonds, insurance portfolio products, patents, etc. producing dividends, interest, annuities, and royalties not arising in the ordinary course of a trade or business owning such property;
  2. Property in (1) above but aggregated in a mutual fund or other pooling device and generating gain or loss from holding or selling such property;
  3. Property held for investment in non-passive activities, although an exception has been granted for one type of passive activity, namely, a working interest in an oil or gas property held directly or through an entity not limiting taxpayer’s liability; and
  4. Any interest in a non-passive trade or business activity in which the taxpayer is not a material participant.

Gross income from investment properties includes the following items:

Net investment income is gross income less reasonable investment expenses, other than interest, with a credible and proximate relation to the production or collection of income from investment properties. There is a catch–investment expenses are classified as miscellaneous expenses and therefore deductible only to the extent they total more than 2% of adjusted gross income. Common investment expenses include accounting fees, investment counseling, legal fees, and rent for safe-deposit boxes.

Other relevant articles on the investment interest deduction follow below:

Many happy returns, Roger

Medical Expenses

Posted on August 1, 2008 
Filed Under Deductions, Federal Income Tax | Leave a Comment

It is no accident some writers use the adjective “extraordinary” to describe medical expenses as this cluster of costs qualifies as an only if it totals more than a hefty 7.5% of (AGI). A single taxpayer reporting in 2007 AGI of $75,000 and paying $5,600 in medical expenses and $6,000 for the miscellaneous expense of job-related legal fees would be in the unhappy situation of being able to itemize (legal fees alone, even after subtracting the 2% of AGI floor for miscellaneous expenses, are greater than the $5,350 standard deduction amount) yet unable to deduct medical expenses because they fall short of the 7.5% AGI floor or $5,625 ($75,000 x 7.5%). Although not subject to phase out, medical expenses fall under the iron sway of the and its harsher 10% AGI floor for high income taxpayers.

However, there is good news for the self-employed: health insurance premiums for the business owner and his or her spouse and dependents are not subject to the 7.5% AGI floor. Instead, these premiums are 100% deductible. But an individual is not required to be self-employed in order to take an above the line deduction for certain medical expenses. For example, the unreimbursed cost of a checkup required by an employer is a miscellaneous expense that is deductible but subject to a 2% AGI floor, but an employee required to pay for and pass a physical exam as a condition of continued employment may take an above the line deduction for this expense.

What are ? Paraphrasing the Internal Revenue Code, deductible medical expenses are unreimbursed amounts paid for diagnosing, mitigating, treating, and preventing disease. The cost of a procedure or treatment affecting the body’s structure or function is also deductible.

A taxpayer can deduct medical costs for a dependent even if the dependent doesn’t qualify for the regular dependency exemption. In other words, the restrictions on claiming individuals as dependents are relaxed for medical deductions:

A taxpayer’s share of unreimbursed payments of a dependent’s medical expenses under a multiple support agreement (e.g., brothers and sisters agree to share in the support of a parent in need of medical services at a nursing home) is deductible even if that dependent doesn’t pass the gross income test. Payments of a deceased spouse’s or dependent’s medical expenses are deductible in the year paid. Even if the executor of the deceased spouse’s or dependent’s estate pays decedent’s medical expenses within one year of date of death, the survivor can still deduct these expenses by filing an amended return.

An abbreviated list of products, procedures, and services eligible for the medical expenses deduction follows below:

For the most part, capital expenditures are not deductible, but a special exception applies if the main purpose of a home improvement is to provide medical care or benefits. The excess of the actual cost of the medical home improvement over the increase in the home’s fair market value is deductible as a medical expense; the remainder of the cost outlay is booked as an increase in the home’s basis. Ramps, railings, support bars, bathroom modifications, and other structural changes not increasing the value of the home are fully deductible.

Generally speaking, medical expenses beneficial to general health, costs of cosmetic surgery to improve appearance, and payments for illegal treatments or drugs are not deductible. Any portion of a judgment or settlement earmarked for medical care is a nondeductible reimbursement. In the case of a policy providing both medical and nonmedical benefits, the medical portion is deductible only if it is reasonable in relation to the total premium and separately stated.

Despite the large number of available medical expense deductions, the most significant benefit for the taxpayer comes not in the form of a deduction but rather by way of an exclusion. Section 106(a) of the Internal Revenue Code excludes from the employee’s gross income health insurance premiums paid by the employer: “gross income of an employee does not include employer-provided coverage under an accident or health plan.” According to several sources, this is the largest single exclusion from income in the Code for individual taxpayers. The exclusion from an employee’s gross income of health insurance premiums paid (and deducted) by an employer is arguably the most important exception to the longstanding rule that (pdf file) deductible by one party in a transaction are taxable income to the other. However, there is a stopgap in the form of a timely application of the : payments received under health insurance plans are not excludable from income to the extent the taxpayer has benefited from prior deductions. And, as emphasized in the definition above, a taxpayer can only deduct medical expenses not compensated by insurance or otherwise, that is, only unreimbursed expenses are deductible.

Additional relevant articles on the deduction for medical expenses are listed below:

Many happy returns, Roger

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