We all love a great tip.
Taxes is a lot like dieting. Everyone wants less taxes and less weight. Everyone is looking for a miracle recipe that does not require much effort, preferably none. And everyone has friends who are “in” on the latest and greatest fad.
Why, then, we’re still not quite in shape and still pay taxes? While nutrition is (obviously) not my forte, I suspect that dieting and reducing taxes fail for the exact same reason: it is not nearly as simple as your friends and casual bloggers paint it. There is no magic pill.
One of the most fashionable lose-your-taxes-while-you-sleep recipes is the home office deduction. A well-known CPA recently blogged on the popular among investors BiggerPockets site:
3 Reasons I Love the Home Office Deduction
- No additional money out of pocket
- Easy to claim
- New simplified calculation
What’s not to love, indeed? Sounds like a winner to me.
Except that it often does not work this way. My colleague forgot to mention a crucial detail: in order to take advantage of the home office deduction, you need to qualify for it first. Most landlords and most “weekend investors” will not qualify.
In order to take advantage of the home office deduction, you need to qualify for it first. Most landlords and most “weekend investors” will not qualify.
First hurdle: Regular use.
The IRS requires that you use the home office “on a regular basis”, whatever it means. Without a reliable definition, the issue often ended up in courts. In some cases, the courts held that 10-15 hours a week was not enough. Beware.
Second hurdle: Exclusive use.
This is a dangerous trap, because the IRS and the courts interpret it literally: exclusive, as opposed to almost exclusive. You may be working in your den all day, but you cannot claim it, because in the evening you watch TV there. If one of your bedrooms had been converted into an office, but your out-of-town cousin slept there during Thanksgiving holiday – you completely disqualified your home office. Yes, one night a year IS a problem for the IRS. Yes, it was challenged in court. The IRS won.
Third hurdle: Principal place of business.
This rule has been relaxed in the recent years. As long as you need your home office to do substantial administrative work, such as returning calls, billing, bookkeeping, etc. – you are safe.
You need to be careful, however, if you also have another office elsewhere, such as a desk at your broker’s office. Having another office does not automatically disqualify your home office, but please read the small print very carefully or, better yet, consult a tax professional.
Fourth hurdle: Must be business or trade.
How can that be a problem? For landlords, it is. But of course, we all have a real estate business – we are investors, for crying out loud! Well, not so fast. The IRS takes a position that owning rental properties is not a business. They call it passive activity instead.
While it may seem to be just another label for the same thing, the consequences are dramatic. Passive activities are not allowed regular business expenses, except those specifically connected to a particular property. Mortgage interest, taxes, insurance, and repairs are OK. Business overhead expenses like general marketing, education and – of course – home office are not.
You think I’m making it up? Then try to enter education and home office in the rental section of your tax software. How did it go? Exactly.
At this point, the teenage girls would type OMG. There must be a way for buy-and-hold investors to deduct all those expenses! Well, there is – provided that your rental business is big enough and active. What is big enough? In one case, the Tax Court ruled that managing 6 rental properties constituted a business. Does it mean your 6 properties are safe from the IRS attack? Not necessarily, but your chances are good. Does it mean 5 properties is not enough? Not necessarily, either, but 2 properties is certainly risky. Are you a risk taker when it comes to the IRS?
The worst part is that, even if you pass the “business” hurdle as a landlord, the next one will probably kill the deal anyway.
Fifth hurdle: The business must be profitable.
Now, this is a true deal breaker. Home office deduction can reduce your taxable profit, but it cannot increase your tax loss.
Home office deduction can reduce your taxable profit, but it cannot increase your tax loss.
To illustrate, if you are a wholesaler making $50,000 net after all expenses, and your home office deduction is $2,000 – you will owe taxes on $48k instead of $50k. However, let’s say this is your fist year in business, and your marketing expenses were greater than income by $10k. You have a $10,000 tax loss. Your $2,000 home office expense cannot turn this $10k loss into a $12k loss. Instead, this extra $2k loss will roll into the next year for a future deduction.
Because of the rollover treatment, the home office deduction is not wasted in a slow year but only delayed. Eventually (hopefully), the business will turn a profit, and you will be able to “catch up.”
Not for the landlords though. Thanks to depreciation deduction and sometimes aggressive treatment of other deductions, most rental properties show a tax loss. Every single year. In this case, the home office deduction will keep rolling from year to year, gradually growing in size, but never usable. Kind of defeats the purpose, doesn’t it?
I am not saying that landlords should forget about home office deduction altogether. I am saying that this issue is complicated and controversial, so it warrants professional advice. Most of the time, unfortunately, home office deduction will not reduce a landlord’s current taxes.
Is it even worth the hassle?
Great question. As you probably expect, the answer is – it depends.
Suppose your house is 2,000 sq ft, and 200 sq ft of it is your office. This is 10%. You are allowed to deduct 10% of all house-related expenses: mortgage interest, taxes, insurance, utilities, repairs, etc., plus 10% of depreciation. This simple description is highly misleading, because you can always deduct 100% of mortgage interest and property taxes. Home office does not create an additional deduction but merely moves 10% of it from one place on your tax return to another, with no (or minimal) reduction to your overall taxes. Bummer.
This leaves us with 10% of everything else. If annual insurance, utilities and repairs on the house total $10,000, then the home office deduction equals to 10% of it, or $1,000. At the typical 25% tax bracket, you will save yourself $250. Yes, this is extra money in your pocket, but not a lot of money, sadly. Depreciation will add a few bucks, however it will also create the depreciation recapture hassle when you sell the house.
How about that new simplified calculation?
It is good news, for a change. You can now avoid the hassle of tracking every utility and repair bill and simply take $5 per square foot, up to the maximum of 300 sq ft. In our example of a 200 sq ft office, it will be $5 x 200 = $1,000 – the very same deduction, minus the recordkeeping trouble. I welcome the simplicity of it. Just remember: you still have to qualify under those 5 criteria we discussed earlier.
What do I do with my office furniture, computers, and office supplies?
They are all deductible, just not on the home office portion of your tax return. And this is a good thing, because you do not have to pass the five tests. Even if you do not have an eligible home office that will fit the IRS definition – you can still take a deduction for that laptop and the comfy chair. As long as they are used for your business, of course.
Any more rules?
I wish I could tell you no. But it is the IRS. There are always more rules, and then exceptions to the rules, and then exceptions to the exceptions.
And this is why you need a good real estate accountant on your team.