- Use the office exclusively and regularly as a principal place of business
- Use the office exclusively and regularly as a place to meet or deal with patients, clients or customers in the normal course of business
- Use the office in connection with a trade or business – but only if the office is a separate structure
Friday, July 3, 2015
This time we are talking about an office-in-home. Many of us have one, but few of us can actually claim a tax deduction for it.
The office-in-home deduction has five main rules, two of which are highly specialized. The remaining three require one to:
If you are an employee, then you are in the trade or business of being an employee. If your office is in a separate structure, you are home-free under test (3).
OBSERVATION: I suppose a converted, oversized shed could meet this test.
I have a CPA friend who practices out of her basement. She would qualify under test (2), as she regularly meets with her clients there. I however almost always meet clients either at their office or mine, so I would not qualify.
That leaves us with test (1), which is an almost impossible standard to meet if one has an office elsewhere. Fortunately there was a Supreme Court decision a number of years ago (Soliman), which allowed one to consider administrative or management duties for purposes of this test.
Soliman was an anesthesiologist, and the three hospitals where he worked did not provide him with an office. He used a spare bedroom for work-related activities, such as contacting patients and billing. The IRS had previously taken a very hard line with test (1) and denied the deduction. The IRS reasoned that Soliman’s job was to put people to sleep, and he did that job at the hospital. This meant that the hospital was his “principal” place of business. The IRS was not going to be persuaded otherwise, at least until the Supreme Court told them to knock it off and allow Soliman his deduction.
Great. So I can do administrative work at home – such as scheduling or billing – and have my office qualify for a deduction, right?
Not so fast.
There are two more tests if one is an employee. The one that concerns us is the requirement that the office be for the convenience of the employer.
Those words sound innocuous, but they are not.
For most of us, having an office at home is for our convenience. In fact, the IRS takes this farther, arguing that – if your employer provides you with an office – then it is virtually impossible for the home office to be for the employer’s convenience. The IRS reasons that the employer would not care if you showed up, as it had an office waiting. There are some exceptions, such as telecommuting or requiring work hours when the office is closed, but you get the idea. For the vast majority of employees, one cannot get past that convenience-of-employer test.
What if one is self-employed? Forget the convenience test. There is no employer.
Let’s look at McMillan v Commissioner. There will be a quiz at the end.
Denise McMillan had a couple of things going on, but what we are interested in is her home office. She was self-employed.
She claimed an office-in-home deduction on her 2009 return. I am not certain of her housing situation, but her office was 50% of her home. I cannot easily visualize how this is possible, especially given the requirement that the office space not be used for any other purpose. That is a lot of space that she is not using for another purpose – like living there.
She lived in a condo. She had gotten into it with the homeowners association over construction defects related to mold and noise, dogs running wild, dogs barking incessantly and leaving dog memorabilia as dogs will when running wild and barking nonstop.
The condo association would do nothing, so she sued them.
The condo association – highlighting the quality of its Board – sued her back.
Wow, send me a flyer so I can consider buying at this bus station to paradise.
All in all, she was out over $26 thousand in legal fees and expenses.
And she deducted 50% of them through her office-in-home deduction.
QUIZ: Is this a valid tax deduction?
She sued because of events which were interfering with her use and enjoyment of her property. Had this property been exclusively her residence, the conversation would be over. But one-half of it was being used for business purposes.
She next had to show that the litigation also had an effect on her business activity.
QUESTION: Have you decided yet?
The Court observed that she was suing over noise, animal waste and similar issues. She argued that they were affecting her ability to work. Makes sense to me.
The IRS did not challenge her argument.
NOTE: My hunch is that the IRS was relying upon an origin-of-claim doctrine. The lawsuit originated from a personal asset – her residence – so the tax consequences therefrom should remain personal. In this case, personal means nondeductible.
Since the IRS did not challenge, the Court could not – or would not - conclude that there was no effect on her ability to work.
The IRS had not challenged the 50% percentage either.
So the Court decided that she was entitled to a tax deduction for 50% of her legal expenses.
By the way, how did you answer?
Friday, June 26, 2015
Someone asked me during the busy season how I came up with the topics for this tax blog.
It is whatever catches the eye of a somewhat-ADD 30-year tax CPA. We are a bit of a garage tax blog, I guess.
What caught my eye this week was another case concerning rental property. It gives us a chance to talk about the “vacation home” rules. If you have a second home, odds are good that you and your tax preparer have talked about these rules.
Let’s say that a person – let’s call him Steve – buys a second home. It is in Tennessee. Steve likes Tennessee.
There are three things that Steve can do with his home in Tennessee:
(1) It can be a true second home. Steve, Mrs. Steve and Steve-descendants use it whenever they can. No non-Steves use the home.
(2) It can be rented. Steve never uses it, as it is being rented to non-Steves.
(3) Steve uses it some and rents it some.
It is (3) that drags us into the vacation home rules.
Let’s recall what the tax difference is between owning a house as a primary residence and owning it as a rental:
(1) Primary residence – you can deduct…
a. Mortgage interest
b. Real estate taxes
(2) Rental – you can deduct…
a. Mortgage interest
b. Real estate taxes
c. Operating costs, such as utilities and insurance
d. Maintenance costs, such as mowing in the summer and snow removal in the winter
As you can see, there is a wider range of potential tax deductions if only we can qualify Tennessee as a rental.
Congress and the IRS know this. That is how we got the vacation home rules to begin with. You cannot rent out the place one week out of year, use it personally the rest of the time and deduct everything that is not tied down.
Our Code section is 280A and it is a math quiz:
(1) Did you rent the place for less than 15 days during the year?
(2) If no …
a. Did you use it personally less than 10% of the days it was rented out?
Let’s go through it.
(1) If you rent the place for two weeks or less, the rental income is not taxable. Mortgage interest and real estate taxes are deductible the same as a residence.
COMMENT: Makes no sense, right? The IRS is actually letting you NOT REPORT income? How did that get in there? I bet it has something to do with Augusta and the Masters. It helps to know people who know people.
(2) You rent it out more than two weeks and use it more than 10% of the rental days.
Congratulations, you have a second home. You also have rental income. You have to report the rental income, but the IRS is kind enough to allow you to take rental deductions UP TO A POINT. You cannot claim so many deductions that you reach the point of a tax loss. You must stop at zero
The deductions get allocated between the personal use days and the rental use days. It’s only fair.
Since it is a second home, you get to deduct whatever interest and taxes were not allocated to the rental as personal mortgage interest and personal real estate taxes.
(3) You rent it out more than two weeks and use it less than 10% of the rental days.
You still have to allocate the expenses as we discussed in (2), but the IRS now allows you to claim a rental loss. Why? Because at less than 10% personal use the IRS does NOT consider this to be your second home. The IRS considers it a rental.
There is a downside, though. You know that mortgage interest allocated to the personal use? It is not deductible anymore. Why? Because the only thing that made it deductible before was that it was attached to your second home. As we said, under scenario (3) the IRS considers this to be a rental, meaning it is not your second home.You do get to deduct the real estate taxes allocated to the personal use. Taxes have a different tax treatment.
There are some special rules on counting days. For example, days spent repairing or maintaining the property do not count, either as personal use or as rental. You might want to document these days well, though.
What if Steve wants to allow Steve-descendants to use the place?
Most of the time this will not work. The reason is that Steve-descendants are considered to be Steve, and that means personal use days.
But there is small exception…
Steve-descendants will not be considered to be Steve if:
· They pay fair market rent, and
· They use the place as their principal residence
It is the second requirement that causes the problem. Put the house in Hilton Head or Key West and odds are that no one is using the place as a principal residence.
However, put a Steve-descendant into medical school in Tennessee and you may have the beginnings of a tax plan.
Our case this week is Cheryl Savello v Commissioner. She had more than one thing going, but our interest is whether she got to treat a Nevada property where her daughters stayed as rental property.
Her daughters used the place as their principal residence.
The Court agreed that the rent appeared to be market value, citing offers to rent from third parties.
But the Court decided that there was no rental. The daughters’ use was attributable to their mother.
Her daughters didn’t pay the rent.
Friday, June 19, 2015
I am reading that Representative Scott Peters (D-CA) has proposed a change to the tax Code allowing forgiveness of credit card balances to be nontaxable.
I have two questions for you:
First, what is it with politicians from California?
Second, did you know that credit card forgiveness was taxable?
The tax Code is based on the concept of an increase in net wealth. The concept is simple, although it causes difficulty in application. Let’s look at the following example:
Monday morning you have to your name
Tuesday the credit card company forgave
Friday you got paid
You put gas in your car
You bought lunch all week
Friday afternoon you have to your name
You went from being worth $400 to being worth $1,425. Does that mean that you have $1,025 of income to report to the tax man? No, but you are thinking along the correct lines. Not every addition in our example is taxable, and not every subtraction is deductible. Let’s look at each.
- $125 of your credit card balance was forgiven.
Code section 108 addresses the taxability when somebody forgives your debt. There are five subcategories:
· 108(a)(1)(A) applies in bankruptcy
· 108(a)(1)(B) applies if you are insolvent
· 108(a)(1)(C) applies to farm debt
· 108(a)(1)(D) applies to certain business debt
· 108(a)(1)(E) applies to your mortgage
I am not seeing an exception for credit cards, so for the time being it looks like the $125 will be income. I am assuming that you are not insolvent (meaning that you owe more than you are worth) or in bankruptcy (which sometimes follows owing more than you are worth).
- Your paycheck
That one is obvious. We should be thankful the government does not just decide to have all paychecks sent to them, allowing them to decide how much to return to us.
- Buying gas and a week’s worth of lunches
Code section 262 disallows tax deductions for personal, living and family expenses. Granted, another Code section may override and allow a deduction for specific expenses (such as medical), but in general one cannot deduct groceries, utilities, rent and similar day-to-day-living expenses.
I would say that you have taxable income of $125 plus $1,000 = $1,125.
The credit card is a subset of “forgiveness of indebtedness” taxation. The seminal case is Kirby Lumber, which was decided by the Supreme Court back in 1931. Kirby Lumber had previously issued bonds of over $12 million. They later bought back the bonds for $137,000 less. The question before the Court was whether that $137,000 represented taxable income. It does seem a bit odd that someone can have income just from transacting in debt, but if you think of it as accession to wealth the tax reasoning becomes clearer. At the end of the day Kirby Lumber was worth $137,000 more (as it had less net debt), and the government wanted its cut.
Back to Representative Sun-Dance-Whispered-By-Hidden-Shadow, or whatever he is called back in his native land.
He is proposing that forgiveness of credit cards be excluded from income.
However, the most that a person could exclude from lifetime income is capped at $2,500.
Say that you excluded $1,000 in 2014. Under his proposal, the most you could exclude – over the rest of your life – is another $1,500. You cannot exclude more than $2,500 over your lifetime.
My first thought is that $2,500 is not enough to move the needle, if someone really got into credit card and personal debt problems. I have known and heard of people who have run up a mortgage-level balance on their credit cards.
My second thought is whether this is a wise use of the public purse. Congress provided a mortgage interest deduction because it wanted to increase home ownership. It provided a charitable deduction to promote societal benevolence and reduce strain on the public safety net. What is Congress saying by providing an exclusion for not repaying credit card debt?
And you can see how bad tax law happens. There is no theory of wealth creation, case precedence or administrative practicality at play with this proposal. An elected bludger panders, laws are passed without being read and the tax system (both the IRS and advisors) is left to making sense out of nonsense.