Why would you live in a home for two years out of every five, and work in it for the other three? Why would you not take a tax deduction you're entitled to? Nobody ever said that US tax laws encourage rational behavior.

by Mark E. Battersby [February 14, 2001]

The expense of using a portion of your home exclusively for business purposes is, as everyone knows, tax deductible. Not too surprisingly, most ISP operators who qualify for a home office deduction usually take full advantage of it.

Unfortunately that home office expense deduction may not always be advisable.

Our tax laws have long contained a deduction for expenses associated with a home office operation, so long as it is exclusively used on a regular basis as the principal place of the ISP business. The Taxpayer Relief Act of 1997 expanded the definition of a principal place of business.

Today, an office located in the home qualifies as a principal place of business if:

• the office is used by an ISP operator for the administrative or management activities of his or her ISP business; and
• there is no other fixed location of that ISP business where the operator conducts substantial administrative activities.

Many operators claim a tax deductions for a portion of their expenses such as home mortgage interest and property taxes, insurance, maintenance and utilities that are associated with the use of a home office. Even a depreciation allowance for the portion of the residence used as a home office is allowed. That depreciation allowance, however, may be one reason why some ISP operators may wish to ignore the home office expense deduction.

Deduction downside
The same tax law changes that opened up the home office deduction to more taxpayers (TRA '97) also expanded the amount of gain resulting from the sale of a residence that could be excluded from income or ignored by dropping the age 55 or older restrictions. Today, any taxpayer, regardless of age, may exclude from taxable income the first $250,000 ($500,000 for married couples filing joint returns) of gain from the sale or exchange of a principal residence.

However, in order to qualify for this exclusion, the property must be owned and used by the taxpayer as a residence for periods aggregating two or more years during the five-year period ending on the date of sale.

Thus, an operator claiming a home office deduction may not always be able to exclude the entire amount of gain on the sale of his or her personal residence.

First, gain must be recognized for the depreciation deductions taken on a home office. Second, the entire portion of the home used as an office is ineligible for exclusion if it isn't used as a principal residence for two out of every five years before the sale.

Under our tax rules, gain resulting from the recapture or payback of straight-line depreciation (the method required for most buildings and portions of buildings) is considered to be an unrecaptured Section 1250 gain. That Section 1250 gain is, of course, subject to a maximum tax rate of 25 percent. Thus, that recaptured depreciation, Section 1250 gain, is taxed at a rate of only 25 percent while today's depreciation deductions may offset income that is taxed at a 28 percent rate.

For more on Section 1250, see various parts of the IRS website including the page on depreciation and the page on selling a house which has a detailed example.

For those who'd like to see some numbers, we have reproduced the IRS' very clear example. Too see it, click here.

Two-on, three-off tax strategy
Many ISP operators may want to forego the home office deduction entirely. This strategy is particularly advisable for operators with relatively few home office expenses and with a large, built-in gain on a principal residence that they are certain that they will sell in the near future. The tax savings from claiming a home office deduction may not be sufficient to offset the loss of part of the home sale proceeds exclusion (Section 121).

Of course, taking full advantage of the home office deduction may still be advisable for some operators—even if they are planning to sell that principal residence. Anyone with a large amount of home office expenses may be better off taking an immediate deduction even though they have to recognize that gain in the future. The savings in self-employment taxes alone may make the immediate deduction of home office expenses the most advisable course of action. The continued deduction of home office expenses is usually advisable if the expected gain on the sale of the home is small.

A two-on and three-off strategy involves using the office for personal use—disqualifying it as a principal place of business—for two years, followed by using it exclusively as a home office in three years. This strategy ensures that the portion of a principal residence used as a home office will always qualify for gain exclusion.

Will you benefit more from an immediate deduction for the expenses of maintaining a home office or from ignoring that deduction, even if only for three out of five years?

Only you can make that decision.

No ISP operator can possibly predict the future with any degree of certainty, so the home office expense deduction should not be undertaken blindly—it might end up costing you more than the deduction is worth.

— End