Potential tax savingsBy Kevin OConnell, JD, CPA
The Treasury Department recently issued new rules that could result in substantial tax savings for physicians who use their principal residence for business, have two or more residences, or have vacant land adjacent to their residence.
The general rule is that you can claim a home office deduction if an area of your home is exclusively used on a regular basis as your principal place of business.
In the Taxpayer Relief Act of 1997, Congress expanded the principal place of business test to include an office used by the taxpayer to conduct administrative or management activities. Managerial tasks at the home office include billing patients, record keeping, reading medical journals, preparing for presentations, and scheduling appointments. In this situation there can be no other fixed location where the taxpayer conducts substantial administrative or management activities.
Further, there is an exception to the principal place of business test if the business part of your home is a place where you meet patients and their use of your home is substantial and integral to the conduct of your medical practice. In this situation, the home office qualifies even though the physician maintains another office performing similar functions away from home.
If you are compensated as an employee, you must also prove that the home office is for the employers convenience rather than your own.
For other ways to qualify a home office as business deduction or limitations on claiming the deduction see IRS Publication 587.
If your home office qualifies for business use, you can deduct the depreciation on the space used exclusively as your home office, as well as property and casualty insurance premiums, repairs and utilities allocable to your home office.
Exclusion of gain on the sale of your home and home office
When you sell your home, you sell your home office as well. Under a 1997 tax law, Congress provided that a homeowner could exclude up to $500,000 of gain ($250,000 if single) from taxable income. This exclusion is a significant tax shelter for appreciating residential real estate. To qualify for the exclusion, a taxpayer must meet an ownership and use test. The taxpayer must have owned the home and lived in it as a primary residence for at least two of the five years before the sale.
Old law on business portion of gain
Prior to the new rules, if the taxpayer used part of their home for business during the two-year ownership and use period, the exclusion generally applied only to the gain attributable to the non-business portion of the home. Depreciation claimed on the structure was (and still is) recaptured at a special tax rate on gain attributable to depreciation on real property.
New law on business portion of gain
The rules released in December 2002 provide the physician who utilizes a home office with a significant tax break and a refund opportunity. The gain attributable to both the business and non-business portion of the home will qualify for the exclusion. This tax break will not apply if the home office is in a structure separate from the principal residence. The exclusion applies to the business portion used within a principal residence but not the business portion treated as a rental unit. For example, if a taxpayer owns a three-floor apartment building and uses two floors as his principal residence, the taxpayer must still recognize gain attributable to the third floor.
Ownership of more than two residences
If the taxpayer owns two residences, tax planning to comply with the rules is required. The determination of which residence is the principal residence is a facts and circumstances test. The taxpayer must identify the principal residence because the $500,000 exclusion only applies to the taxpayers principal residence.
If the taxpayer stays in a residence in successive periods, the factor given a considerable amount of weight is where the taxpayer spends a majority of the time during the year. When the time spent is not successive, other factors are also considered, such as where the taxpayers medical practice is located, where the taxpayers family resides and the address listed on the taxpayers federal and state tax returns, drivers license, automobile registration and voter registration card. Further, other factors, such as banks, religious and clubs with which the taxpayer is affiliated, will be considered in determining the taxpayers principal residence. Once the principal residence is established, the taxpayer must meet the two-year ownership and use test prior to the date of sale to qualify the residence for the exclusion.
Adjacent vacant land
Vacant land will qualify for the exclusion provided the land is adjacent to land containing the dwelling unit and the taxpayer meets the ownership and use test with respect to the vacant land. The term "dwelling unit" includes a house, apartment, condominium, mobile home, boat or similar property and all structures or other property appurtenant to such dwelling unit.
The vacant land does not have to be sold on the same date nor to the same buyer as the principal residence but must be sold within a 24-month period before or after the sale of the principal residence. Although the sale dates occur at different times, the combined exclusion for the sale of adjacent vacant land and the principal residence cannot exceed $500,000 ($250,000 if single). If you sell the vacant land before the principal residence, you may have to pay the tax and apply for a refund in the year you sell the principal residence.
Indirect ownership of principal residence
Taxpayers who own their residence through a trust or a single member limited liability company may still qualify for the exclusion. The physician may have set up a trust to shift some or all of the value of the residence and future appreciation to the taxpayers heirs for estate tax purposes. During the term of the trust the $500,000 exclusion will remain with the taxpayer for income tax purposes. The regulations provide that even if the residence is owned through a trust or single member limited liability company, the taxpayer can claim the exclusion.
Example on excluding business portion of gain:
A physician bought a home in 1998 for $150,000. He allocated $20,000 to the land and $130,000 to the structure. He used 10 percent of the square footage in the house for meeting patients and other medical professionals.
In 2003, he sold the home for $250,000. He is married and filed a joint return in 2003. His gain on the sale of the home is $100,000. He claimed $2,000 in depreciation in the prior five years. Only $2,000 of the gain, equal to the depreciation deductions in prior years, would be taxable income. The maximum tax rate assessed on such depreciation recapture is 25 percent.
Keep in mind that in the prior years the physician was able to deduct the depreciation at his ordinary income tax rate of 39.6 percent. He reduced his overall tax in the five-year period because of the tax rate differential. The tax rate differential is the difference between his top marginal federal rate of 39.6 percent and the federal tax assessed on depreciation recapture of 25 percent. In our example, the federal tax savings over five years was $292 ($2,000 depreciation recapture x 14.6 percent). The savings would even be greater for a self-employed physician because the depreciation also reduced self-employment tax. The state tax implications will vary by state. And, the physician does not have to report the gain attributable to business use of $10,000 (gain of $100,000 x 10 percent business use).
Importantly, these rules can be applied retroactively. So, assume a physician with similar facts as stated above sold a home in 2001 and reported not only the depreciation recapture but also the gain attributable to business use of $10,000. The physician can claim a refund of the tax paid on the $10,000 gain because the 2001 tax year is still open.
Kevin OConnell is a tax principal in the Tax Services Group at Somerset in Indianapolis, Indiana. He assists health care professionals and their related business.