Renting a Home Office To An Employer

A client asked about the home office deduction last week.

This deduction has lost much of its punch with the Tax Cuts and Jobs Act of 2017. The reason is that employee home office deductions are a miscellaneous itemized deduction, and most miscellaneous itemized deductions have been banned for the next two-plus years. 

The deduction still exists for self-employeds, however, including partners in a partnership or members in an LLC. Technically there is one more hoop for partners and members, but let’s skip that for now.

Say you are working from home. You have a home office, and it seems to pass all the bells-and-whistles required for a tax deduction. Can you deduct it?

Depends. On what? On how you are compensated.

(1) If you are a W-2 employee, then you have no deduction.

(2) If you receive a 1099 (think gig worker), then you have a deduction.

Seems unfair.

Can we shift those deductions to the W-2 employer? Would charging rent be enough to transform the issue from being an employee to being a landlord?

There was a Tax Court case back in the 1980s involving the tax director of a public accounting firm in Phoenix (Feldman). His position involved considerable administrative work, a responsibility difficult to square with being accessible to staff at work while also maintaining confidentiality on private firm matters.

Feldman built a house, including a dedicated office.  He worked out an above-market lease with his firm. He then deducted an allocable share of everything he could against that rent, including maid service.

No surprise, Feldman and the IRS went to Tax Court.

Let’s look at the Code section under dispute:

Sec 280A Disallowance of certain expenses in connection with business use of home, rental of vacation homes, etc.

(a)  General rule.

Except as otherwise provided in this section, in the case of a taxpayer who is an individual or an S corporation, no deduction otherwise allowable under this chapter shall be allowed with respect to the use of a dwelling unit which is used by the taxpayer during the taxable year as a residence.

Thanks for the warm-up, said Feldman., but let’s continue reading:

      Sec 280A(c)(3) Rental use.

Subsection (a) shall not apply to any item which is attributable to the rental of the dwelling unit or portion thereof (determined after the application of subsection (e).

I am renting space to the firm, he argued. Why are we even debating this?

The lease is bogus, said the IRS (the “respondent”).

Respondent does not deny that under section 280A a taxpayer may offset income attributable to the rental of a portion of his home with the costs of producing that rental income. He contends, however, that the rental arrangement here is an artifice arranged to disguise compensation as rental income in order to enable petitioner to avoid the strict requirements of section 280A(c)(1) for deducting home office expenses. Because there was no actual rental of a portion of the home, argues respondent, petitioner must qualify under section 280A(c)(1) before he may deduct the home office expenses.

Notice that the IRS conceded that Feldman was reading the Code correctly. They instead were arguing that he was violating the spirit of the law, and they insisted the Court should observe the spirit and not the text.

The IRS was concerned that the above-market rent was disguised compensation (which it was BTW). Much of tax practice is follow-the-leader, so green-lighting this arrangement could encourage other employers and employees to shift a portion of their salaries to rent. This would in turn free-up additional tax deductions to the employee - at no additional cost to the employer but at a cost to the fisc.

The IRS had a point. As a tax practitioner, I would use this technique - once blessed by the Court – whenever I could.

The Court adjusted for certain issues – such as the excess rent – but decided the case mostly in Feldman’s favor.

The win for practitioners was short-lived. In response Congress added the following to the Code:

      (6)  Treatment of rental to employer.

Paragraphs (1) and (3) shall not apply to any item which is attributable to the rental of the dwelling unit (or any portion thereof) by the taxpayer to his employer during any period in which the taxpayer uses the dwelling unit (or portion) in performing services as an employee of the employer.

An employer can pay rent for an employee’s office in home, said Congress, but we are disallowing deductions against that rental income.

Our case this time was Feldman v Commissioner, 84 T.C. 1 (U.S.T.C. 1985).