IRS Makes Income Limit Mistake on the Home-Office DeductionTax Planning
Can the IRS ever be wrong?
If the IRS is wrong, what’s your strategy?
You use the office in your home as the administrative office for your business.
You use your downtown office as your sales or patient office. The downtown office is the office location where you make the cash register ring.
What percentage of your gross income comes from the office in your home?
Why do you need to know this?
Because the IRS Says...
Pub. 587. In its home-office publication, the IRS says that because (a) part of your gross business income comes from your home office, and (b) part comes from your downtown office, you must identify the part that comes from your home office.
To do this, the IRS tells you to consider
- the time you spend at each location,
- the business investment in each location, and
- any other relevant facts and circumstances.
Why This Is Wrong
What you see in the IRS publication and instructions comes from the IRS 1983 proposed regulations, which were rejected by Scott, made obsolete by the legislative history in the Tax Reform Act of 1986,5 and then withdrawn by IA-023-93 on May 19, 1993.
How the Withdrawn Regulations Worked
The now-withdrawn regulations define gross income derived from the business use of the home as gross income from the business activity in the unit, reduced by expenditures required for the activity but not allocable to the use of the unit itself, such as expenditures for supplies and compensation paid to other persons.
Here’s how the IRS explains it (emphasis added by us):
For example, a physician who uses a portion of a dwelling unit for treating patients shall compute gross income derived from use of the unit by subtracting from the gross income attributable to the business activity in the unit any expenditures for nursing and secretarial services, supplies, etc.
Rejection by Scott
In Scott, the Tax Court rejected the proposed regulation, holding that gross income from the use of the home means gross income from the business activity itself.9 In other words, when you have two or more offices and one is the home office, the gross-income limit applies to the business, not to the activity that occurs in each separate office.
Scott Made Congress Worry
Lawmakers worried that the Scott case could allow home-office deductions that could cause an increase in a business-loss deduction.
The combination of the Scott case and the IRS proposed regulation11 caused lawmakers to adopt the current law, which is best summarized by the wording in the Conference Report on the Tax Reform Act of 1986, as follows:
...the amount of an otherwise allowable home-office deduction is limited to the taxpayer’s net income from the business (i.e., gross income minus deductions attributable to the business). Disallowed home-office deductions may be carried forward to later years, subject to the new income limitation in such years.
What This Means
The law does not require you to divide your gross income between your home office and a downtown office.
Further, the law does not limit the home-office deduction to the income generated from the home-office income.
What the law does is look at your entire business income from all locations for that business and then apply the gross-income limit to the home-office deduction. The law also requires you to carry over to the next year any business loss created by the home-office deduction.
To give you a big-picture look, consider this taxpayer who has both an office downtown and an office in his home that he uses as his administrative office for the business:
- If he had to use a 20 percent allocation of gross income, his home-office deduction would be zero, and he would deduct only his home-office percentage of his mortgage interest and taxes ($34,000, in our example).
- If he had to use a 60 percent gross-income allocation, his home-office deduction would be $52,020.
- But with what we believe is the proper percentage (100 percent), he deducts $64,744.
Facing the IRS
The legislative history clearly states that there’s no separate income limit on the office in your home. The income limit applies to the entire business.
The old proposed regulations contain the old wording that was first declared incorrect by the Tax Court (a case with precedence) and then nullified by the 1986 law.
Although issued after enactment of the Tax Reform Act of 1986, the IRS acquiescence to the Scott case appears to miss the new-law fact that the gross-income limit applies to the business as a whole, and it seems to say that the obsoleted regulation is okay. The acquiescence’s fussy wording could have prompted the incorrect wording in the
IRS’s publication and in its instructions on how to claim the home-office deduction.
So, if you have to square off with the IRS on this issue, you have the law on your side. On the big scale of justice, having the tax law on your side is about as good as it gets in winning your deductions. Both David and Goliath are in your corner.
Your home-office deduction does not increase any tax loss from your business. If you are in a loss situation, the home-office deduction allows the deductions for the business percentage of your home mortgage interest and property taxes. The remainder carries over to the next tax year.
With a business loss, the percentage of your gross income has no effect on your home-office deduction.
But that sneaky line 8 on IRS Form 8829, where you might use the IRS Form 8829 worksheet to make an entry that says your use of the office is only 20 percent of your business, is where the trouble comes in. Remember our example: the 20 percent produced no deduction for business expenses.
Make sure you check your tax return to see whether you are using a percentage that’s hurting your home-office deduction. Our sample taxpayer gained more than $30,000 with the correct percentage (100 percent).