Excerpted from: Tax Planning Strategies for the Self-Employed
Much mysticism surrounds the home office deduction. Many tax accountants continue to advise their clients to avoid the home office deduction. They may say that any depreciation deduction will have to be recaptured if/when they sell their home. This was always a silly argument. As of December 2002, this argument does not apply.
Examples assume 15.3 percent self-employment tax, a 28 percent federal income tax bracket and no state income tax:
Depreciation. Depreciation expense for the business use portion of your home is otherwise not deductible. A mere $1,000 deduction for depreciation could save you $433 (i.e., 28 plus 15.3 equals 43.3 percent multiplied by $1,000) per year, every year.
Depreciation Recapture. Some do not deduct their home office out of fear of later depreciation recapture. In effect, fear of a later gain. However, even if you later sell your house and recapture (in effect, a reversal of the depreciation deduction or a gain) applies, there is a permanent tax savings of the self-employment tax at 15.3 percent. It is for this reason that the decision to avoid this legitimate deduction was always a poor one. The permanent tax saved is $153 ($1,000 multiplied by 15.3 percent) per year, every year. And even if there were no permanent tax savings, tax deferral was still achieved (e.g., I reduce taxes for 5 years and have to pay these tax savings back in the 6th year, after 5 years of interest-free use of these tax reductions.)
New IRS Ruling. IR-2002-142, December 23, 2002 and Treasury Decision 9030 and 9031 were published in the Federal Register on December 24, 2002. In short, they explain how you can now take your entire $250,000 ($500,000 if married, filing jointly) exclusion on the gain on your personal residence, INCLUDING THE GAIN ON DEPRECIATION RECAPTURE. It’s just that simple, but it gets better…
Amending Returns. This change is RETROACTIVE! Generally, you have three years to amend your tax returns…the IRS has a similar audit window. If you have failed to take the home office deduction due to fears of depreciation recapture, you can amend these returns and get additional refunds (plus interest). Similarly, if you have recaptured depreciation from a home office deduction over the past three years, you can amend these returns and get additional refunds (plus interest).
Utilities and Maintenance. The business use portion of otherwise non-deductible utilities, repairs, and other operating expenses also result in permanent income tax and self-employment tax savings. For example, again using $1,000, additional permanent tax savings of $433 result per year, every year.
Non-Itemizers. For non-itemizer taxpayers, the business use portion of real estate taxes and home mortgage interest become deductible. Again, using the $1,000 example, additional permanent tax savings of $433 result per year, every year.
Itemizers. For itemizer taxpayers, the business use portion of real estate taxes and home mortgage interest shifts from the taxpayer’s Schedule A to their Schedule C. This results in a permanent tax reduction of an additional 15.3 percent for the self-employment tax, or $153 per year, every year.
A Recommendation. If you prepared your own tax return this year, you probably used one of the many inexpensive tax software packages available at office supply stores. I recommend the purchase of a very inexpensive version, usually at a cost of about $10. (If you prepared prior year’s returns on software and need to amend these returns, you may still have these files on your computer or a disk!)
Run pro forma’s or “what ifs.” Start by determining the percentage of your personal residence used regularly and exclusively for the production of income in your home business. For example, assuming that this amount is only 10 percent, “what if” you deducted 10 percent of your home repairs, maintenance, utilities, depreciation, real estate taxes, mortgage interest, etc., as a home office?
Limitations and other strategic considerations may apply, so be sure to print out a copy of this article (and your “what ifs”) and discuss them with your tax accountant!
Tax Planning Strategies for the Self-Employed will help you reduce (or even eliminate) self-employment, federal and state income taxes through strategies that have proved useful for more than two decades.
As adapted (and extended) from Chapters 10 and 11 of Tax Planning Strategies for the Self-Employed (3rd Edition) by A.J. Cataldo, Ph.D., CPA, CMA.