Deducting the Home Office: Who Cares About Recapture?

By: Anthony Cataldo
Submitted: 2007-01-17 16:17:40
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Introduction
The home office deduction is one of the least understood deductions. Many taxpayers avoid the deduction, frequently on the advice of their tax accountant or attorney, for fear of an IRS audit or concerns over the recapture of depreciation when their personal residence is later sold. This article will provide a brief description of the tax savings components associated with the home office deduction for both itemizer and non-itemizer taxpayers and provide some net present value illustrations so that you can see the impact of the recapture of depreciation when your personal residence is sold. The impact is modest.

The IRS provides detailed instructions on Business Use of Your Home in its Publication 587. This publication is updated every year and is provided to the public, for free, by calling the IRS tax forms 1-800 telephone number or by downloading the publication from the Internet at www.irs.gov . Home office deductions are reported on Form 8829, Expenses for Business Use of Your Home. You should print this article out and discuss it with your tax accountant.

Why deduct the home office?
Self-employed taxpayers establish a home office for several reasons. First, they already own or rent a home, so operating out of their personal residence reduces the duplication of overhead and/or the maintenance of a separate office or place of business. The reduction of overhead, and related monthly cash outlays for the additional expense associated with rent, utilities, etc., reduces business risk and business failure rates. Establishment of the home office as the principal place of the self-employed taxpayer's trade or business also minimizes non-deductible commuting expenses and increases the business use percentage of the business use automobile, not to mention the reduction in the consumption of fuel. In summary, one might be inclined to argue, successfully, that the home office and the legitimate use of the home office deduction is good for the U.S. economy.

Who qualifies for legitimate use of the home office deduction
To qualify for the home office deduction, you must use the business portion of your home…
 Exclusively (except for inventory storage or day-care facilities)
AND
 Regularly for your trade or business
AND
(1) Your principal place of business
OR
(2) A place where you meet or deal with patients, clients, or customers in the normal course of your trade or business
OR
(3) A separate structure (detached from your home) used in connection with the trade or business.

What are the benefits of legitimate application of the home office deduction?
There are several reasons why taxpayers, legitimately entitled to do so, should deduct their home office:
 Real estate taxes and mortgage interest - itemizer. The business use portion of otherwise deductible real estate taxes and home mortgage interest are shifted from the taxpayer's Schedule A (itemized personal deductions) to the Schedule C (deductible business expenses). The legitimate shifting of the business use percentage of the taxpayer's home from Schedule A (reducing both federal and state income taxes) to Schedule C (reducing federal and state income and self-employment tax) results in the additional reduction of the 15.3% self-employment tax. The self-employment tax savings are permanent.
 Real estate taxes and mortgage interest – non-itemizer. For taxpayers otherwise unable to itemize, the business use portion of otherwise deductible real estate taxes and home mortgage interested are deducted on the taxpayer's Schedule C. In this case, the taxpayer benefits from combined federal and state income and self-employment tax savings for these deductible expenses that would otherwise provide for no tax savings. In this case, federal and state income and self-employment tax savings for the non-itemizer taxpayers are permanent.
 Utilities and other expenses. The business use portion of otherwise non-deductible expenses such as: utilities, repairs, homeowner's association dues, basic cable, etc., are converted to deductible business expenses. Not only are the related self-employment tax savings permanent, but federal and state income tax reductions are also achieved. All of these tax savings are permanent.
 Depreciation. The depreciation of the business use portion of the taxpayer's home is otherwise not deductible. This expense is deducted on the taxpayer's Schedule C and results in a reduction of the 15.3% self-employment tax. Even if the taxpayer later sells the house and has to recapture the depreciation deducted, resulting in repayment this component of tax savings, a temporary federal and temporary state income tax deferral and permanent self-employment tax savings from depreciation results.

The first step -prepare a loan amortization schedule. If you own a home, prepare a loan amortization schedule for your home mortgage. I will use an example of a $250,000 home with a 10% down payment ($250,000 multiplied by 10% equals $25,000; $250,000 less $25,000 equals $225,000). The monthly principal and interest payments, at an 8% interest rate, are approximately $1,975 per month for 360 months/30 years.

Permanent self-employment tax savings from home mortgage interest. Over the life of the mortgage, the taxpayer will pay about $485,825 in home mortgage interest. Ignoring inflation (and deflation) and assuming 28% federal income tax and no state income tax (for simplicity) the taxpayer will save $136,031 ($485,825 multiplied by 28%) in federal income taxes. (This calculation is, of course, simplified. I have not considered the standard deduction amount that would be available to non-itemizers.) If 10% of the taxpayer's personal residence is used for business purposes, an additional $7,433 ($485,825 multiplied by 10% equals $48,583, which is multiplied by 15.3%) in self-employment taxes would be saved. Keep in mind, this example of self-employment tax savings (1) is permanent, (2) represents a minimal amount of business use (at 10%), and (3) ignores the other tax savings, previously described. Some additional facts require consideration.

Permanent self-employment tax savings from real estate taxes. Assume that the taxpayer's real estate taxes are $1,500 per year. Of course, these amounts will increase with inflation over time. Again, ignoring inflation of the cost and deflation (to present value) of the tax savings, assume that the taxpayer uses 10% of the home for business purposes. This would result in the transfer of 10% of this cost, $150 ($1,500 multiplied by 10%), from the taxpayer's Schedule A to the taxpayer's Schedule C. The result is additional, permanent self-employment tax savings of $23 ($150 multiplied by 15.3%, rounded) per year, every year.

Permanent tax savings from depreciation (net of recapture). The previous examples have dealt with home mortgage interest and real estate taxes. These items are always deductible, as itemized personal deductions, but have been shifted from the taxpayer's Schedule A to their Schedule C, resulting in additional, permanent self-employment tax savings. We will now proceed to those expenses otherwise not deductible.

Assume that the taxpayer's cost of $250,000 can be allocated between land (not depreciable) and building at 40% and 60%, respectively. The taxpayer can depreciate the building cost of $150,000 ($250,000 multiplied by 60%), but cannot depreciation the land, which is a non-wasting asset that does not experience functional or economic obsolescence.

Using the post-1998 39-year straight-line depreciation, this expense would produce annual federal and self-employment tax savings of approximately $167 ($150,000 multiplied by 10% business use equals $15,000, which is divided by 39 to provide $385, in annual depreciation expense, multiplied by the 43.3% combined federal income and self-employment tax rate). If state income tax applies, the annual tax savings would be higher.

Again, the savings resulting from depreciation of 10% of the taxpayer's personal residence seem modest. However, these savings occur each and every year.

Permanent tax savings from homeowner's insurance. Assume that the taxpayer pays an annual amount of $500 in homeowner's insurance. At 10% business use, the taxpayer will be able to deduct only $50 ($500 multiplied by 10%) per year on the Schedule C. However, these savings are, again, permanent. For a taxpayer in the 28% federal income tax bracket, combined federal income and 15.3% self-employment tax savings will approximate $22 ($50 multiplied by 43.3%) per year, every year.

Permanent tax savings from utilities and repairs. Utilities and repairs are generally not deductible. However, for the taxpayer legitimately qualifying for the home office deduction, we can, again, assume 10% business use for utilities and repairs expenses.

A summary example at 10%, 20%, 30% and 40% business use. The above examples and illustrations have separately reviewed the benefits of the home office deduction. TABLE 1 summarizes results where the taxpayer (1) qualifies for the home office deduction, (2) is in a 28% federal income tax bracket, (3) purchased a $250,000 home with 10% down and the remaining 90% financed at 8% for 30 years, (4) allocates the cost between non-depreciable land (at $100,000) and depreciable building (at $150,000), (5) pays real estate taxes of $1,500 per year, (6) pays homeowner's insurance at $500 per year, and (7) pays utilities and repairs at $4,500 per year.

TABLE 1 shows federal income tax (at a 28% bracket) and self-employment tax savings for 10%, 20%, 30%, and 40% business use, respectively. These tax savings occur annually, every year. Time value of money considerations has been ignored. If the taxpayer were to sell the home in the eighth year, a one-time recapture-related federal income tax of $755 (at 10% business use) would have to be paid.

Finally, TABLE 1 ignores the additional business use-related deductions and tax savings associated with the reduction of non-deductible commuting and the related increased business use of the taxpayer's vehicle (a separate topic, beyond the scope of this brief article).

TABLE 1

Ex. 1 Ex. 2 Ex. 3 Ex. 4 Business use… ...at 10% ...at 20% ...at 30% ...at 40%
First Year Expenses:
Home mortgage interest $ 2,244 $ 4,489 $ 6,733 $ 8,978
Real estate taxes $ 150 $ 300 $ 450 $ 600
equals: Shifted from Sch A to C $ 2,394 $ 4,789 $ 7,183 $ 9,578
multiplied by: 15.3% SE tax 15.3% 15.3% 15.3% 15.3%
equals: Addit'l SE tax $ 366 $ 733 $ 1,099 $ 1,465

Depreciation $ 385 $ 770 $ 1,155 $ 1,540
Homeowner's insurance $ 50 $ 100 $ 150 $ 200
Utilities and repairs $ 450 $ 900 $ 1,350 $ 1,800
equals: Added to Sch C $ 885 $ 1,770 $ 2,655 $ 3,540
multiplied by: 43.3% 43.3% 43.3% 43.3% 43.3%
equals: Addit'l FIT & SE tax $ 383 $ 766 $ 1,150 $ 1,533
add: Addit'l SE tax (above) $ 366 $ 733 $ 1,099 $ 1,465
Equals: Total tax savings $ 749 $ 1,499 $ 2,249 $ 2,998

Notice that legitimate business use of your personal residence results in (1) the shifting of otherwise deductible personal expenses from your Schedule A to your Schedule C for additional, permanent self-employment tax savings of 15.3%, (2) the deductibility of otherwise non-deductible repairs and utilities expenses on your Schedule C for additional, permanent federal and state income and self-employment tax savings, and (3) depreciation expense, deductible on your Schedule C for additional federal and state and permanent self-employment tax savings.

A time value of money or present value extension – recapture included
Would you prefer to have $1 today or $1 one year from today? If you answered "$1 today," you understand the concept of the time value of money. Over time, price levels increase. Generally, automobiles, fuel costs, food and housing costs increase over time. This is due to inflation. Inflation erodes purchasing power.

The selection of the discount rate. Generally, the discount rate is a function of something referred to in finance as the after-tax cost of capital. Any introductory textbook on corporate finance would cover this topic and how the discount rate is developed for corporations. For the individual taxpayer, a similar measure can be approximated.

For our purposes, you should be less concerned with the precise calculation of your particular cost of capital and more concerned with the understanding of the mechanics and the concept of the time value of money. A discount rate of 10% is used to illustrate the present value of the home office deduction. If you want to learn more about cost of capital, merely visit the library and find an introductory corporate finance text. Look in the chapters devoted to present value and net present value.

TABLE 2 illustrates the benefits from the home office deduction, focusing only on the tax deferral from federal income and self-employment taxes. Like TABLE 1, it is important to keep in mind that this illustration ignores state income taxes, which would increase the value (and present value) of this deduction. Furthermore, if the home is sold at a later date, or never sold, the value (and present value) of these tax savings would increase further. Finally, more than 10% business use would increase the value (and present value) of this deduction significantly.

Converting TABLE 1 results to present value. TABLE 2 illustrates the tax savings associated with 10%, 20%, 30%, and 40% business use of a taxpayer’s personal residence at a 28% federal income tax and 15.3% self-employment tax rate (i.e., 43.3% when combined). TABLE 2 uses this same fact pattern, but only for the first year (for simplification) used in TABLE 1. TABLE 2 develops and illustrates the present value of the decision to legitimately exploit the home office deduction, and assuming that the taxpayer sells his/her personal residence and is, therefore, subject to recapture of the depreciation component, in time period/year 8 at the constant 28% federal income tax rate or bracket.

TABLE 2 Time Tax PV

Period Amount Adjustment Factor PV
Business use at 10%
Annual Tax Savings 1-7 $ 749 100% 4.87 $3,648
Depreciation Recapture 8 $(2,695) 28% 0.47 $(355)
Net Present Value $3,293

Business use at 20%
Annual Tax Savings 1-7 $ 1,499 100% 4.87 $7,300
Depreciation Recapture 8 $(5,390) 28% 0.47 $(709)
Net Present Value $6,591

Business use at 30%
Annual Tax Savings 1-7 $ 2,249 100% 4.87 $10,953
Depreciation Recapture 8 $(8,085) 28% 0.47 $(1,064)
Net Present Value $9,889

Business use at 40%
Annual Tax Savings 1-7 $ 2,998 100% 4.87 $14,600
Depreciation Recapture 8 $(10,780) 28% 0.47 $(1,419)
Net Present Value $13,181

Summary
This very brief excerpt used the home office deduction to illustrate time value of money considerations and permanent tax savings associated with the home office deduction. They result from a simple fact pattern, selected and designed to correct misconceptions. Specifically, the issue of depreciation recapture was explored. However, this framework may be used to examine a variety of tax planning fact patterns. Copy or print out this very brief article and discuss these results with your tax accountant.

Feel free to publish or reproduce anywhere, as long as you provide a copy to and/or notify the author .

Article source: Expert Articles