BY GREG MERMEL, C.P.A.
Every once in a while, the Internal Revenue Service (IRS) surprises me. They issued new regulations on Dec. 23, 2002, which will make me rethink the advice I give clients about taking a home office deduction. Call it a Christmas present that was delayed in the mail.
What’s So Surprising?
About five years ago, Congress passed a major overhaul of the tax law involving the sale of one’s home. The old rollover rule, allowing you to defer gain if you promptly bought a new house of greater or equal value, was replaced with one that said the first $250,000 of gain on the sale of your home ($500,000 for married couples filing joint returns) was nontaxable if you had owned and occupied your house for two of the five years preceding the sale. As typically occurs, the law sets out a principle, giving the IRS authority to work out the details through regulations to be issued later.
"Later" is the key word in that sentence. The IRS is short-staffed and has a hefty backlog. Once started, the actual process for developing and issuing regulations is slow and tedious. The proposed regulations have to be developed internally at the IRS, and that can take time if various internal factions interpret the legislation differently. After several reviews and approvals, the proposed regulations are published for public commentary.
They do actually receive a number of comments, particularly on regulations like these that will apply to many taxpayers. Granted, few of them are from what you would call "the public." Most remarks come from tax practitioners–that is, people with the patience, background and inclination to actually read such technical mumbo-jumbo and make sense of it. After the public comment period, the proposed regulations are revised. If the revisions are extensive, the IRS will go through another cycle of publishing the proposed regulations and inviting commentary. Typically, though, we only know about the changes to the proposed regulations when the final regulations are published.
Almost always, final regulations are less generous to taxpayers than the proposed regulations, mostly because the comments have directly or indirectly exposed ways in which the regulations could be twisted in an undesirable manner. This time, however, the final regulations were more generous.
About That Office
As I have explained several times in this column, a home office has to meet certain tests for deductibility. Greatly simplified, they require that the office be a part of your home (a) regularly and exclusively used for business purposes, and (b) used either as the principal place of business, or the only permanent management site for a business, or for the convenience of one’s employer.
For renters, my advice has always been simple and obvious. If the office qualifies, take the deduction. In so doing, you have taken nondeductible expenses and made them deductible.
But for homeowners, the advice has been less clear-cut. The biggest components of the deduction would be mortgage interest and property taxes. These expenses are already deductible, though you may get a greater tax savings through the home office deduction because of self-employment taxes, limitations on itemized deductions and other complex interactions that you really do not want me to explain. All you are adding is the proportionate share of utilities, insurance, your house cleaner, and depreciation.
Depreciation was the problem in the past. Generally, if real estate is used partially for business and partially as your home, it is treated as if it were two separate parcels. For example, I both own and live in a three-flat. If I were to sell it, I could only exclude gain from the half where I live; the gain on the other half would be taxable. Under all the guidance the IRS had provided over the past five years, and under the proposed regulations, this concept would apply if a homeowner had taken a home office deduction. A fraction of the gain would be taxable, equal to the percentage used for the home office.
The final regulations changed this so long as your office is part of your dwelling unit, i.e., not a separate building or apartment. All of the gain would qualify for the exclusion, with one exception: If you have taken depreciation on your home office after May, 1997 (the effective date of the new home sale rule), the gain you must include would be no more than the amount of the depreciation. This gain is taxed at your regular rate for the year of the sale, or 25 percent, whichever is lower.
For me, that makes the advice simple: Take a deduction now, and pay tax on the same amount of income at some indefinite future date–possibly at a lower rate. In a small way, it is a return from the grave of the depreciation-based tax shelters that flourished in the late 1970s and 1980s, without the Barnum-like atmosphere and often dubious legality.
More In Santa’s Bag
These same new regulations are surprisingly generous in some other ways. A home that you occupy for only part of the year can, in some circumstances, be treated as your primary residence for the entire year for the two-out-of-five years test. Another provision of the 1997 law provides a partial exclusion for those who do not meet the two-out-of-five test due to change in place of employment, health or unforeseen circumstances. Normally, the IRS takes a narrow, Dickens-villain-like view of "unforeseen circumstances" but these are amazingly broad. They include (if not otherwise contradicted by the overall facts and circumstances) not being able to keep up with the mortgage due to changed financial circumstances, divorce, break-up with a domestic partner, a letter from your doctor, and–I love this one–multiple births from a single pregnancy.
Call It A Valentine
If you would like a free copy of my "Checklist of Potentially Deductible Items for Actors, Designers and Others in the Performing Arts," just send me your name and address.
Are there money or tax questions you would like to see discussed in this column? Let me know, at 2835 N. Sheffield, Suite 311, Chicago, IL 60657, or call 773/525-1778 (888/525-1778 toll-free outside the Chicago area) or e-mail greg@gregmermel.com.
Greg Mermel is a certified public accountant whose clients in the arts range from individual performers to major theatre companies and suppliers. He also sometimes produces theatre.