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Home Office Deductions

The ins and outs of filings forms, which forms (pdf files), and what deductions with retirement and health plan deductions

Date:   1/14/2006 12:54:46 PM   ( 14 y ) ... viewed 1628 times

Depreciation Appreciation 101: The Ins and Outs of Deducting for a Home Office

Published: January 14, 2006
Every year at tax time, Robert Sigal, a San Diego chemical engineer specializing in computer simulations of chemical plants, would take his home office as a deduction.

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Sandy Huffaker for The New York Times
Robert Sigal, a San Diego chemical engineer, often works from his home office.

Explanation of the home-office deduction:

Business Use of Home

IRS Publication 587 (PDF) (See page 14, bottom of the first column)

IRS Publication 523 (See business use and rental property)

Information on the 2002 rule change on in-home office deduction

Home Office rules

Instructions for Forms 8829 (PDF)

Instructions for Form 4562 (PDF)

Instruction on Calculating the Cost Basis of Your Home

IRS rules on depreciation
It is something he is entitled to do under the byzantine federal tax code because his employer doesn't have offices in his area. He converted a spare bedroom in a condominium he bought in 2001 into an office and filled it with three computers and other equipment.

To reduce his taxes, he depreciated the value of the office real estate, as one would depreciate the value of a copy or fax machine. The more it is used, the less valuable it becomes because of wear and tear and obsolescence, the theory of depreciation goes.

But San Diego condos were not losing value. Prices were rising sharply. When Mr. Sigal sold the condo last January, he made a tidy profit; the unit had more than doubled in price. He would not have to pay taxes on the profit because the Internal Revenue Service allows a single person a $250,000 exemption as long as the home has been lived in for 24 months.

He thought he was off the hook until his accountant warned that he was going to owe as much as $5,000 more in taxes. "I wish I hadn't taken the deduction," Mr. Sigal said. "The lesson here is that I should have contacted my accountant before I sold the place."

What Mr. Sigal discovered may be happening to other taxpayers this year. The most feared surprise tucked into the tax code is being socked with the alternative minimum tax, a tax intended to hit the very richest but that now applies to the middle-class taxpayer. But as home prices have risen so sharply in cities across America over the last five years, more homeowners may find themselves paying a bit more in taxes than they had anticipated because they keep a home office. They also might find themselves confused.

The I.R.S. allows you to take a home office deduction if you meet certain conditions, and about 30 million taxpayers manage to meet them. The rules are pretty clear for the self-employed. The home office has to be the primary place of business, used exclusively and regularly for that business. If your office fits that definition, you can write off a percentage of the utilities, the mortgage, repairs and maintenance and, of course, all the office equipment and furniture stuffed into it.

But for those who work for a company, some accountants see only a little wiggle room. If your employer provides an office for you, but you choose to work at home, you cannot use the home office deduction. You cannot write off an office even if it is used strictly to manage your stock portfolio, but you could if you were a day trader. If your employer's office is closed on weekends or does not have air-conditioning in the summer or heat in the winter on those weekends, you still cannot claim a home office, according to many - but not all - tax accountants contacted for this article.

There is a lot of gray area when dealing with tax regulation, accountants said. But what is crystal clear is that when you sell your home for a profit you have to recapture the depreciation you took on that office and pay taxes on it. For example, say you bought a house for $500,000 and used 10 percent of it for an office. (You figure that out by measuring the square footage of the office and dividing that by the square footage of the entire house.) You are allowed to depreciate 10 percent of the purchase price of the house each year using what the government succinctly calls the "39-year commercial property straight time depreciation schedule." That adds up to about $6,000 in depreciation over five years.

You later sell the house for $750,000. The $250,000 in profit is excluded from tax. But the $6,000 you took in depreciation over the years must be reported as a gain on Schedule D, in the gains and losses section. It is taxed at a 25 percent rate.

What if you take other home office deductions and skip the depreciation? Nancy Mathis, an I.R.S. spokeswoman, says that will not help. "Even if you don't take this depreciation, it will be treated as if you did when it comes times for calculating the basis of the home sale and capital gains exclusion." The I.R.S. will not say why it makes that assumption, but accountants surmise it is because the government cannot keep track of home-office owners who might depreciate some years and then stop right before selling in hopes of avoiding the extra tax.

Here's something to think about: If you rent, you avoid this entire frustration when claiming a home office deduction.

Now for the more complicated question: Remember that the government allows a single person to exclude $250,000 of capital gains on a home sale and a married couple, $500,000. If you claimed 10 percent of your home as a home office and wrote that off over the years, when you sell the house, do you owe capital gains tax on 10 percent of the profit? This is what is tripping up Mr. Sigal, the chemical engineer.

Explanation of the home-office deduction:

Business Use of Home

IRS Publication 587 (PDF) (See page 14, bottom of the first column)

IRS Publication 523 (See business use and rental property)

Information on the 2002 rule change on in-home office deduction

Home Office rules

Instructions for Forms 8829 (PDF)

Instructions for Form 4562 (PDF)

Instruction on Calculating the Cost Basis of Your Home

IRS rules on depreciation
The government used to say, you owe the tax on the portion of the residence that is used for commercial purposes. But it gave taxpayers a little gift when a new rule took effect in 2002. The home office inside the structure of your house is no longer considered commercial property. Everything is covered under the capital gains exclusion. If your accountant is not up to date on that, ask him or her to check it out.

Indeed, Mr. Sigal does not owe as much as he was told and a new accountant confirmed that he owes taxes on only the $2,000 of recaptured depreciation.

But in changing the rules, the I.R.S. also made things more complicated. Funny how that happens. That no-tax rule applies only if the home office is part of the structure of the main residence. "If it is a separate building," said David Gitel, a New York City tax accountant, "you are out of luck." When you work out of a detached garage or shed, you must compute the profit that is attributable to that structure and pay a capital gains tax of 15 percent on it, plus the tax on the depreciation recapture.

In that case, what you can do is make what is called a 1031 exchange. Don't do it without guidance from an accountant, but buy another piece of commercial property within 190 days and you can avoid paying taxes.

Given how complicated it is, many people might ask whether it is worth the bother to deduct a home office on Schedule C, the form for private businesses. Would it be easier to just write off most of the expenses as nonreimbursable business expenses on Schedule A?

Matt Ryan, a certified public accountant with Blair Accounting Services in Lombard, Ill., said the home office deduction might be best avoided. It raises your accountant's bill and might raise your audit exposure. "There is an added compliance cost," he said. (There is mixed opinion among accountants whether a home office deduction is a red flag to tax auditors, but the I.R.S. said it was not cracking down on home office deductions.)

You probably are deducting your interest payments and your property taxes on Schedule A anyway. The benefit to using Schedule C - you'll need two other forms, 8829 and 4562 - is that the mortgage, the taxes and other costs of running the home office decrease the income you made from your home-run business. That means there is less that is assessed the 15.3 percent self-employed Social Security tax. "You get more out of it on Schedule C," Mr. Gitel said.

But if you don't qualify for a home office, Schedule A is the place to deduct business expenses. A good tax accountant will make easy work of this. Tax software, like the Premier edition of TurboTax, can do it, too, and will also walk you through the process of depreciation recapture in a series of interview questions.

You can deduct other things if you have a home business. In addition to a share of utility bills, you can deduct an extra phone line, any business equipment you buy or the business use of the car.

You can hire your spouse as an employee and provide medical insurance. He or she puts you on her medical plan and your business swallows the cost as a business expense, reducing your taxable income. Retirement accounts for private businesses are also quite generous and another good way to shield income.

As for Mr. Sigal, he has a home office in his new condo. But this time he is cutting his taxes by deducting business expenses that were not reimbursed by his employer.

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