Community Accounting & Tax, LLC., Chester, Virginia, Serving Metro Richmond and Southside Virginia.

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• IRS Back To Its Old Nasty Tricks
• Congress Ducks AMT ReliefI
• IRA Swap-Bill Could Cost US Treasury Billions
• Special Report On New Tax Legislation

HOME OFFICE DEPRECIATION ISSUES

To reduce their taxes, one of our new clients previously 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 many homes and condos are not losing value (now). Prices are rising sharply, for now. When the new single clients sold his condo last January, he made a tidy profit; the unit had more than doubled in price. The client 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 he was warned by his old accountant that he was going to owe as much as $5,000 more in taxes. "I wish I hadn't taken the deduction," said the new client, obviously somewhat upset and worried. The lesson here is that he should have contacted us before he sold the place, and his old “accountant” was a chain ‘storefront tax mill.’.
 

What our client 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 (AMT for short), a tax intended to hit the very richest but that now applies to the middle-class taxpayer. But as home prices have risen sharply in cities across America (including Metro-Richmond) 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 very 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 may or may not claim a home office.  The facts and circumstances must be looked at very carefully before a decision is made in these regards

There is a lot of gray area when dealing with tax regulations. 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 or convention as we accountants call it." That adds up to about $6,000 in depreciation over five years.

You later sell the house for $750,000 (its a nice house). 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? The I.R.S. Code is quite clear, 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 we 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.  However, with E-file, that will be coming to an abrupt end. 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 our new client.
 

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 the accountant you use is not up to date on that, ask him or her to check it out.

Indeed, our new client does not owe as much as he was told and we advised him 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 (which goes back to the days when the I.R.S. insisted your home office be detached in order to take the deduction) 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? But Schedule A only gives you about $32.00 for every $100.00 in allowable deductions

Some say the Home office deduction might be best avoided. They postulate it could raise raises your accountant's bill and might raise your audit exposure. There is an added compliance cost that must be paid, nothing but air is free. (There is mixed opinion among accountants whether a home office deduction is a red flag to tax auditors, but the I.R.S. says it was not cracking down on home office deductions.)  And, if you are legitimately taking the deduction, you should not lose sleep over it. The same is true for anything else on your tax return.  And, those who would tell you that “if you do, you will be audited” are generally wrong. However, we do stress that; (a) the deduction must be legitimate and, (b) you must be able to substantiate it by clear and convincing evidence.

You probably are deducting your interest payments and your property taxes on Schedule A anyway - at least you should be. 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, and far more important, the I.R.S. says you are entitled to the deduction !
 

But if you don't qualify for a home office, Schedule A is the place to deduct business expenses, albeit limited. A good tax accountant will make easy work of this.

You can deduct other things if you have a home business. In addition to a share of utility bills, you can deduct an extra (not the first) phone line, any business equipment you buy, the business use of the car - and more.

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 (limitations apply). Retirement accounts for private businesses are also quite generous and another good way to shield income.

As for our new client, 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.