Business Use of the Home – Part 4 – Should you claim it, or not?
(This is Part 4 of a four-part series. Read Part 1, Part 2 and Part 3 first.)
The Benefits
There are some really great benefits that can come from taking the Business Use of the Home deduction. First, not only does the deduction allow you to write-off expenses that are normally non-deductible, but it allows self-employed individuals to reduce their income taxes and their self-employment taxes. Most personal deductions can only be taken against income tax, whereas these count against the self-employment tax as well. This results in an extra 15% tax savings on top of whatever marginal income tax rate you are in.
Second, there are certain itemized deductions on Schedule A that are limited, and the home office deduction can reduce the effects of those limitations. For example, if a person’s AGI is too high the amount of real estate taxes that they are able to deduct from their Schedule A is reduced. If a portion of those taxes are claimed as business expenses the limitation becomes smaller or is eliminated, allowing more to be deducted and some to even be deducted for the purposes of the self-employment tax. Another example of this is found in the $1 million limitation on mortgages (interest on mortgages of greater amounts cannot be deducted). With the Business Use of the Home deduction the excess interest that could not be claimed on Schedule A can be used for the business-use deduction, as long as it can be shown that the excess is as a result of the business.
Finally, for those whose home office is their principal place of business, a mileage deduction can be claimed for anywhere the individual goes for business purposes. Under normal circumstances, the distance of the commute between the home and the office is considered a personal expense and cannot be deducted. Only those trips that are conducted after the arrival at the office can be claimed. However, when the home is the office, any business travel can be claimed. It is not uncommon for this mileage deduction to add up to much more than the Business Use of the Home deduction.
The Potential Drawbacks
While it is exciting to realize that you can deduct some of your “personal” expenses from your business income, it is important to know that there are potentially significant downsides to doing so. I have included in this section some of the things to consider before taking deductions for the business use of your home, as well as precautions to take if you choose to claim the deduction.
When you sell your home there may be tax consequences.
Thoughtful consideration should be given to the future tax consequences of claiming a deduction for the business use of your home. By declaring that a part of your home is, in essence, business property, you can lose some of the tax benefits of home ownership when you sell the home.
In most cases, when you sell your principal residence you are able to realize up to $250,000 in gains ($500,000 for couples who file jointly) on the home without paying any taxes on those gains. There are specific rules governing this exclusion of gains that I won’t cover here – but for the purposes of this discussion I will just assume that you would otherwise qualify for this tax exclusion.
Example: Mike and Susan purchased their home in 1995 for $200,000 and made an additional $40,000 in improvements. They sold their home in 2010 for $600,000 – a gain of $360,000. If they had realized a gain from the sale of any other asset, they would be required to pay taxes on that gain. In this case the taxes for Mike and Susan would add up to $54,000 ($360,000 gain x 15% capital gains tax bracket = $54,000).
However, because this asset was their main home, the tax code offers an exclusion from tax on the first $500,000 of capital gains if all of the rules are met. Under normal circumstances this would mean that Mike and Susan would not be required to pay the $54,000 in taxes.
When part of the home has been treated as business property, instead of personal property, the rules that govern the exclusion change. The primary difference is that any depreciation that has been taken on the home must be “recaptured.”
The idea behind depreciation is that over time an asset becomes less valuable. For this reason, the tax code allows you to expense, or deduct this loss in value. However, if you have sold the home for a higher price than you bought it for, then the home has not really depreciated in value. For this reason you are required to “recapture” the depreciation you have claimed and then pay taxes on that amount, since you paid fewer taxes in the past by claiming it.
When this depreciation is recaptured it is taxed at rates determined by special tables. The maximum rate for this recapture is 25%, as opposed to the maximum 15% capital gains rate. This is because you have, in the past, taken the depreciation against ordinary income (and sometimes against self-employment taxes as well). So, instead of a gain on your house that would not result in any taxes, you would pay taxes on any amount of depreciation that you have taken.
Example: Mike used his shed for about 6 ½ years before they sold the house. During that time he claimed $3,096 in depreciation. While the gain that he realized from the sale of his personal residence would normally be excluded from taxes, he will have to pay up to $774 in tax on the recaptured depreciation ($3,096 recaptured x 25% maximum rate = $774).
For those whose business use of the home is within the main walls of their residence, this is the only adjustment that will need to be made. For those who claimed a business-use of a structure that is appurtenant to the home, such as Mike’s workshop, there is an additional adjustment to be made. When the portion of the home that was depreciated is separate from the “dwelling unit” the gain on the home must be proportionately divided up and taxes paid on the business portion of that gain.
Example: Mike claimed on his tax return that 8% of his home was used for business purposes. Because his workshop is a separate structure from his home he will have to claim 8% of the gain on the sale of his home as taxable, which would otherwise be excluded under the personal residence rules. This will cost him an additional $4,320 in taxes ($360,000 gain on the sale of the home x 8% of the home used for business x 15% capital gains tax rate = $4,320).
As you can see, there are some potentially significant tax consequences when selling a home that has been claimed for business use. These consequences are compounded by the fact that when the home is sold, the full tax impact happens in one year, whereas the tax benefits of the deduction have been split up over multiple years. The impact of the sale could even change your marginal tax bracket, or cause you to become ineligible for certain tax deductions in that year because your income becomes too high.
In addition, you cannot fully anticipate what the future tax rates will be. You could end up saving a little each year from the deductions in a lower tax bracket, then have the rates change (or your income change) in the future when you sell the home and end up paying a much higher marginal tax. All of these factors should be taken into consideration before claiming a business use of the home.
Tip: There are special ways that the gain on the sale, the excluded portion of the gain, and the recapture of the depreciation need to be reported. I recommend working with a tax professional or studying the IRS publications before finalizing a tax return that contains this scenario.
The amount that you can claim as a deduction may be limited.
While you are allowed to deduct expenses related to the business use of your home against business income, you are not allowed to claim a loss because of those deductions. In fact, there is a specific order in which each expense must be deducted in order to determine which will be allowed and which will not.
First, you must subtract all business expenses that are not related to your home from your gross business income. For example, expenses for things such as office supplies, wages, meals and depreciation of business assets (not including the home) would be subtracted from income first.
The next group of items to be deducted would be those expenses related to your home that you would be able to deduct regardless of business or personal use. These expenses would include mortgage interest and real estate taxes.
If, after these expenses are taken, there remains a positive net income you would then be allowed to subtract other expenses related to the home that would not be allowed as deductions if they were personal expenses. Some examples of these expenses would be utilities, insurance, repairs and maintenance. None of these deductions can lead to a negative net income. Once the net income reaches $0, these deductions must stop.
The final expense that you are allowed to deduct, as long as there is sufficient net income remaining, is depreciation on the business-use portion of the home. As with the previous set of deductions, the deduction for depreciation cannot exceed the net income that remains after all previous deductions.
At no time will the deductions claimed in the third and fourth group be allowed to produce a loss. However, any unused deductions will be carried forward to a future year when there is sufficient income to deduct them.
Example: In 2008 Mike had a hard time selling his woodwork because of the difficult economy. While he made a profit, it wasn’t as much as he was accustomed to. In fact, his income wasn’t even enough to be able to claim all of his Business Use of the Home deduction.
Gross Income $25,000
Ordinary Business Expenses - $21,000
Net Income Remaining $ 4,000
Business % of Mortgage Interest & Taxes - $ 2,300
Net Income Remaining $ 1,700
Other Business-use Expenses - $ 1,500
Net Income Remaining $ 200
Depreciation on Home - $ 492
Net Income – $ 292
Depreciation on the home is not allowed to result a negative net income. For this reason Mike had to carry over $292 of Business Use of the Home deductions to a future year when he had sufficient net income to deduct it from and still leave a positive balance.
As you can see from this example, even if you meet all of the qualifications for the deduction, you may still not be able to use it all in the current year. This lessens the benefit of claiming the deduction at all – unless in most years your income is more than sufficient to be able to claim the full deduction.
Tip: If your net income after non-home expenses is low enough that you cannot even claim all of the business-use portions of your mortgage interest and property taxes, you will want to consider the possibility of not claiming a business-use of your home at all. This is because you may have a greater benefit in being able to claim all of your mortgage interest and real estate taxes on Schedule A (itemized deductions), rather than carry forward the business deductions to a future year. You will only know which is best by playing with the numbers and finding the result of both scenarios in the current year.
Multiple places of business
The above scenario of deductions being limited by the amount of income becomes even more complicated when you have multiple places of business. This is because the deduction is actually limited by the amount of income derived from the business-use of the home. So if you run most of your business elsewhere, and only perform administrative duties at home, for example, it may be difficult to claim sufficient income derived in the home to cover the expenses claimed.
Example: Earlier I used the example of Russ, Mike’s neighbor who is an optometrist. Russ sees 25% of his patients in his home. In this case Russ would only use the income from those in-home visits against the expenses that he claims for the business use of the home, since that is the only business activity that he performs in his home.
Tip: When allocating income to the home, take into account the amount of time spent at each business location, the amount of money spent on capital assets at each location, and an income that is easily attributed to each location.
Audit Risk
As I mentioned in the beginning, the Business Use of the Home deduction is one of the most commonly audited deductions on a tax return. The IRS has not officially admitted that this is the case, or that the deduction increases your chances of an audit. However, there have been a couple instances where high officials in the Service have stated that it is the case in public forums. I have personally been told by an IRS auditor that the computer system ranks that deduction higher on the list of reasons to audit. In addition, IRS statistics show that self-employed individuals are twice as likely to be audited as other individuals. Claiming the Business Use deduction only adds to that risk.
This fact alone is an additional reason to consider whether or not to claim the deduction, even if you are entitled to it. The cost of defending yourself in an audit, both in time and in money, plus the potential for the IRS to find other deficiencies while examining your return, can add up to a lot. If the tax benefit that you are getting from the deduction is small, it may not be worth claiming it.
If you choose to claim the deduction, though, there are several things that you can do to be more prepared for an audit and have a more successful outcome. Why go to all of the work that it takes to calculate and claim this deduction, only to have the IRS disallow some or all of it, and add penalties and interest to boot?
Tip: Some of the things that you can do include to protect yourself are:
- The old mantra for the three most important things in real estate – location, location, and location – can be re-coined for taxes and IRS audits as documentation, documentation and documentation. I can’t stress enough how important good records are in an IRS audit. They can literally make all the difference. For every expense that you claim, be sure to have the documentation (bills, bank statements, etc.) to back it up.
- Have a floor plan of your home that shows the dimensions of each room, drawn to scale. Most of the time the IRS agent will never see your home. This will help the agent to see that your allocation between business and personal use has been made correctly.
- Take a picture of the space that you use for business, from different angles. Take these pictures each year with the date printed on the picture. The audit of your return will usually happen 2-3 years after the actual year of the tax return. In that time you may have moved, changed the layout of the room, or gone out of business and started using the area for personal use. If you have a picture of the way it looked during the tax year it will help a lot when your return is examined.
- It has been found that those who claim to use more than 20-25% of their home for their business are far more likely to be questioned. If you are going to claim more than that, be extra certain that you can back it up.
- If you are renting, send a 1099 to the landlord for the business portion of the rent to help substantiate the expense.
- If you conduct business anywhere besides the home, keep a log book that shows the amount of time you have spent in the home office during the year.
- Be careful not to double-deduct expenses. I have seen people take a deduction for the business portion of their mortgage interest and real estate taxes, and then deduct the full amount of those expenses on their Schedule A as well. This is a simple error, but the IRS computers will quickly pick up the fact that you have claimed more mortgage interest than the bank reported and you have created an automatic flag on your tax return.
- Avoid having multiple years of “losses” on your business, and then having other years of $0 income because of the home business deductions and carry-overs. In my opinion it would be better to show income for your business and pay some taxes than to have losses and $0 income. If you do that for long enough the IRS may say that you have a “hobby,” not a business – and that can mean a lot of taxes, penalties and interest.
- In most cases you can deny the IRS entry into your home if the request a visual examination of your business-use space. Doing so, however, will likely result in the disallowance of all business-use deductions. If the IRS actually wants to see your home, I would strongly recommend getting help from an experienced tax professional who has Power of Attorney to represent you before the IRS.
A look to the Future
Congress has considered a “standard deduction” for the business use of the home. If this change were to come to pass it would greatly simplify the deduction for most people who claim it. The number being bantered around for the standard deduction is $1,500. In order to claim the standard deduction the taxpayer would only have to meet the criteria of business use, but would not have to do all of the record keeping and dividing up of expenses. Let’s all keep our fingers crossed for this change to happen.