Ch 14 Homeownership
Transcript of Ch 14 Homeownership
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Ch 14 Homeownership
Tax and Nontax Consequences of Home Ownership
Nontax Consequences Large investment. Potential for big return (or loss) on investment with use
of leverage. Risk of default on home loan. Time and costs of maintenance. Limited mobility.
Tax Consequences Interest expense deductible. Gain on sale excludable.
Real property taxes on home deductible. Rental and business- use possibilities.
In fact, taxpayers meeting certain home ownership and use requirements can permanently exclude up
to $250,000 ($500,000 if married filing jointly) of realized gain on the sale.3 Gain in excess of the
excludable amount generally qualifies as long-term capital gain subject to tax at preferential rates.
Ownership test: The taxpayer must have owned the property for a total of two or more years during the
five-year period ending on the date of the sale.
Use test: The taxpayer must have used the property as her principal residence for a total of two or more
years during the five-year period ending on the date of the sale.
What qualifies as a principal residence? By definition, a taxpayer can have only one principal
residence. When a taxpayer lives in more than one residence during the year, the determination of
which residence is the principal residence depends on the facts and circumstances such as:
THE KEY FACTS
Exclusion of Gain on Sale of Personal Residence
Must meet ownership and use tests. Must own home for at least two of five years before sale.
Must use home as principal residence for at least two of five years before sale. For married couples to
qualify for exclusion on a joint return, one spouse must meet ownership test and both spouses must
meet use test.
- Amount of time the taxpayer spends at each residence during the year.
- The proximity of each residence to the taxpayers employment.
- The principal place of abode of the taxpayers immediate family.
- The taxpayers mailing address for bills and correspondence.
A taxpayers principal residence could be a houseboat, trailer, or condominium a residence need not
be in a fixed location.
Married couples filing joint returns are eligible for the full $500,000 exclusion if either spouse meets the
ownership test and both spouses meet the principal-use test.
1. If a taxpayer converts a home from a personal residence to a rental property, the tax basis of
the home becomes the lesser of (a) the taxpayers basis at the time of the conversion or (b) the
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fair market value of the home at the time of the conversion (any loss that accrued while the
property was personal-use property disappears at the time of the conversion).
2. If a taxpayer deducts depreciation expense (and reduces the basis of the home by the amount of
the depreciation expense) while renting it, either before or after using the home as a principal
residence, the gain caused by the reduction in basis from the depreciation expense is not
eligible for the exclusion. This gain is unrecaptured 1250 gain subject to a maximum tax rate of
25 percent. See discussion in Chapter 10 for details.
3. If a taxpayer converts a rental home to a principal residence, the basis of the home as a principal
residence is the same basis the home had as a rental at the time the rental home was converted
to a principal residence. Thus, if at the time of the con- version to personal use, the value of the
home is less than the basis of the home, the built-in loss will never be deductible because the
rental use has ceased. To deduct the loss, the taxpayer must sell the home rather than convert
it to personal use.
Once a taxpayer sells a residence and uses the exclusion on the sale, she will not be allowed to claim
another exclusion until at least two years pass from the time of the first sale.
If either spouse is ineligible for the exclusion because he or she person- ally used the $250,000 exclusion
on another home sale during the two years before the date of the current sale, the couples available
exclusion is reduced to $250,000. If a widow or widower sells a home that the surviving spouse owned
and occupied with the other spouse, the surviving spouse is entitled to the full $500,000 exclusion
provided that the surviving spouse sells the home within two years after the date of death of the
spouse.
Unusual or hardship circumstances. A taxpayer may be forced to sell his home before he meets the
ownership and use requirements due to a change in em- ployment, significant health issues, or other
unforeseen financial difficulties. In such cases, the maximum available exclusion is reduced. To qualify
for the exclu- sion due to a change in employment, the taxpayers new place of employment must be at
least 50 miles farther from the residence that is sold than was the previous place of employment. If
there is no previous place of employment, the distance between the individuals new place of
employment and the residence sold must be at least 50 miles.
Exclusion of Gain on Sale of Personal Residence
Exclusion Amount $500,000 for married couples fil ing joint returns. $250,000 for other taxpayers.
Hardship provisions maximum exclusion = full exclusion months of qualifying ownership and use/24
months. Gain eligible for exclu- sion may be reduced for time home is not used as principal residence ifit is being used as a principal residence at the time of the sale.
Taxpayers may choose to use the number of days the taxpayer fully qualified for the exclusion divided
by 730 days.
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Note, as the previous example illustrates, that under the so-called hardship pro- vision, it is the full
exclusion that is reduced, not necessarily the excludable gain. Consequently, if a taxpayers gain on the
sale of a residence is less than the maxi- mum exclusion, the taxpayer may exclude the full amount of
the gain. Finally, the rule limiting taxpayers to claiming one exclusion every two years does not apply totaxpayers selling under hardship circumstances.
Limitation on exclusion for nonqualified use. The amount of gain eligible for exclu- sion may be
limited for taxpayers selling homes after December 31, 2008.11 The limi- tation applies if, on or after
January 1, 2009, the taxpayer uses the home for something other than a principal residence for a period
(termed nonqualified use) and then uses the home as a principal residence before selling it. If the
limitation applies, the percentage of the gain that is not eligible for exclusion is the ratio of the amount
of the nonqualified use divided by the amount of time the taxpayer owned the home (purchase date
through date of sale). Note that this provision does not reduce the maximum exclusion. Rather, it
reduces the amount of gain eligible for exclusion.
Exclusion of Gain from Debt Forgiveness on Foreclosure of Home Mortgage Prior to 2007, if a
lender foreclosed (took possession of ) a taxpayers principal residence, sold the home for less than the
taxpayers outstanding mortgage, and forgave the taxpayer of the remainder of the debt, the taxpayer
was required to include the debt forgiveness in her gross income. However, from January 1, 2007,
through December 31, 2012, taxpay- ers who realize income from this situation are allowed to exclude
up to $2 million of debt forgiveness if the debt is secured by the taxpayers principal residence (the
principal residence is collateral for the loan) and the debt was incurred to acquire, construct, or
substantially improve the home.
A major tax benefit of owning a home is that taxpayers are generally allowed to de- duct the interest
they pay on their home mortgage loans as itemized ( from AGI) deductions.
Taxpayers are allowed to deduct only qualified residence interest as an itemized deduction. Qualified
residence interest is interest paid on the principal amount of acquisition indebtedness and on the
principal amount of home-equity indebtedness. Both types of indebtedness must be secured by a
qualified residence to qualify.
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Qualified residence: The taxpayers principal residence (as described in the previous section) and one
other residence. For a taxpayer with more than two residences, which property is treated as the second
qualified residence is an annual electionthat is, the taxpayer can choose to deduct interest related to a
particular second home one year and a different second home the next. The second residence is often a
vacation home where the taxpayer resides part time. If the taxpayer rents the second residence for part
of the year, the residence will qualify if the taxpayers personal use of the home exceeds the greater of
(1) 14 days or (2) 10 percent of the number of rental days during the year. Consequently, for a second
home to be considered a qualified residence, a taxpayer who rents the home for 100 days must use the
home for personal purposes for at least 15 days, and a taxpayer who rents the second home for 200
days must use the home for personal purposes for at least 21 days. If the taxpayer does not rent out the
property, the taxpayer may choose the property as a qualified residence even if the taxpayers personal
use of the property is 14 days or less.
Home-equity indebtedness: Any debt, except for acquisition indebtedness, secured by the taxpayers
qualified residence to the extent it does not exceed the fair mar- ket value of the residence minus the
acquisition indebtedness. That is, for purposes of deducting interest, total qualifying home-related debtcannot exceed the total value of the home. For example, in a rapidly appreciating real estate
environment, aggressive lenders may offer home-equity loans that result in loan-to-value ra- tios up
to 125 percent. To the extent that the loan exceeds the equity in the home (value minus acquisition
indebtedness), the interest is not deductible. The de- termination of the amount of home-equity debt is
made at the time the loan is executed, so a subsequent decline in a homes value does not reduce the
interest expense deduction.
Borrowers can use the proceeds from a home-equity loan for any purpose, as long as the loan is secured
by the residencehence, the popularity of home-equity loans to consolidate debt and lower monthly
payments. However, as we note in Chapter 7, interest expense on home-equity loans not used topurchase or substan- tially improve the home is not deductible for AMT purposes.
Home-Related Interest Deduction
Deduction allowed for qualified residence interest. Principal residence and one other residence.
If rented out, personal use must exceed greater of (1) 14 days or (2) 10 percent of
rental days to be qualified residence. Acquisition indebtedness. Home-equity indebtedness.
Home-Related Interest Deduction
Acquisition Indebtedness Proceeds used to acquire or substantially improve home. Limited to
$1,000,000. Principal payments permanently reduce amount.
Limitation on amount of acquisition indebtedness. Interest expense of up to $1,000,000 of acquisition
indebtedness is deductible as qualified residence interest. Once acquisition indebtedness is established
for a qualifying residence (or for the sum of two qualifying residences), only principal payments on the
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loan(s) can reduce it and only additional indebtedness, secured by the residence(s) and incurred to sub-
stantially improve the residence(s), can increase it.
When a taxpayer refinances a mortgage, how does the tax law treat the new loan? Assuming the
taxpayer does not use the proceeds from the refinance to substantially improve her residence, the
refinanced loan is treated as acquisition debt only to the extent that the principal amount of therefinancing does not exceed the amount of the acquisition debt immediately before the refinancing.
Consequently, any amount bor- rowed in excess of the remaining principal on the original loan does not
qualify as acquisition indebtedness. Interest on the excess part of this loan can only be de- ducted if it
qualifies as home-equity indebtedness.
Limitation on amount of home-equity indebtedness. As noted earlier, interest on home-equity
indebtedness is deductible as qualified residence interest. However, the amount of qualified home-
equity indebtedness is limited to the lesser of (1) the fair market value of the qualified residence(s) in
excess of the acquisition debt related to the residence(s) and (2) $100,000 ($50,000 for married filing
separately). Thus, a tax- payer can deduct interest on up to $100,000 of home-related debt above and
beyond acquisition debt (limited to $1,000,000) as long as the debt is secured by the equity in the
home(s) no matter what the taxpayer does with the proceeds from the home- equity loan.
Home-Related Interest Deduction
Home-Equity Indebtedness Can use proceeds for any purpose. Loan must be secured by equity in
home (FMV > Debt). $100,000 limit.
When a taxpayers home-related debt exceeds the limitations, the amount of de- ductible interest can
be determined in one of two ways. First, the deductible interest can be computed as the product of (1)
total interest expense on debt secured by the home and (2) the ratio of qualified debt to total debt
outstanding on the home. This average interest expense option is summarized as follows:
The second method is based on the chronological order of when the loans were exe- cuted, rather than
as a weighted average. A taxpayer can choose to deduct all interest on earlier loans up to the limit on
qualifying debt. Once the limit on qualifying debt is reached, interest on debt above the limit is not
deductible.
Home-Related Interest Deduction
If combined debt exceeds limitations Average method: Total interest qualifying debt/total debt.
Chronological method: Deduct interest on loans based on chronological order loans were executed
(FIFO).
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Acquisition debt and home-equity debt can apply to the same loan. Interest-deductible loan of up
to $1.1M secured by the home.
Finally, even though there are separate limits on acquisition indebtedness and home- equity
indebtedness, both limits can apply to the same loan.
Mortgage Insurance Taxpayers are allowed to deduct as qualified residence interest expense premiums
paid or accrued on mortgage insurance (insurance premiums paid by the borrower to protect the lender
against the borrower defaulting on the loan). To qualify, the premiums for the mortgage insurance must
be paid or accrued in con- nection with acquisition indebtedness on a qualified residence and must be
paid by December 31, 2010. The deduction does not apply to mortgage insurance contracts issued
before January 1, 2007. The (itemized) deduction is phased out by 10 percent for every $1,000 (or
fraction thereof) that the taxpayers AGI exceeds $100,000.
Points A home buyer arranging financing for a home typically incurs several loan- related fees or
expenses including charges for points. A point is 1 percent of the prin- cipal amount of the loan. In
general, borrowers pay points to lenders in exchange for reduced interest rates on loans. However,
borrowers may also pay lenders for other purposes (for example, to compensate lenders for the service
of providing the loan). In order for taxpayers to deduct points, the points must be paid for a reduced
interest rate (rather than for the service of providing the loans).
The IRS will treat points as deductible qualified residence interest if the following requirements are met:
1. The settlement statement (see Appendix Athe settlement statement details the monies paid
out and received by the buyer and seller as part of the loan trans- action) must clearly designate
the amounts as points payable in connection with the loan, for example as loan origination
fees, loan discount, or discount points. (These amounts are typically provided on lines 801and 802 of the set- tlement statement.)
2. The amounts must be computed as a percentage of the stated principal amount of the loan.
3. The amounts paid must conform to an established business general practice of charging points
for loans in the area in which the residence is located, and the amount of the points paid must
not exceed the amount generally charged in that area.
4. The amounts must be paid in connection with the acquisition of the taxpayers principal
residence and the loan must be secured by that residence (the deduction for points is not
available for points paid in connection with a loan for a second home).
5. The buyer must provide enough funds in the down payment on the home to at least equal the
cost of the points (the buyer is not allowed to borrow from the lender to pay the points).However, points paid by the seller to the lender in connection with the taxpayers loan are
treated as paid directly by the tax- payer. Consequently, such points are generally deductible by
the buyer.
Note that points paid in refinancing a home loan are not immediately deductible by the homeowner.
These points must be amortized and deducted on a straight-line basis over the life of the loan.
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Real Property Taxes
Real property tax payments are deductible by taxpayers conducting self-employment activities against
business income as for AGI deductions, by landlords against rental income as for AGI deductions, and by
individuals as itemized deductions. As we discussed in Chapter 6, taxpayers who do not itemize
deductions are allowed to deduct real property taxes by increasing the amount of their basic standarddeduction by the lesser of (1) the amount of real property taxes paid during the year or (2) $500 ($1,000
for a married couple filing jointly).
Taxpayers are not allowed to deduct fees paid for setting up water and sewer services, and assessments
for local benefits such as streets and sidewalks.22 Taxpayers generally add these expenditures to the
basis of their property.
The tax deduction is based on the relative amount of time each party owned the property during the
year (or period over which the property taxes are payable). The seller gets a deduction for the taxes
allocable for the period of time up to and including the day before the date of the sale. The taxes
allocable to the day of the sale through the end of the property tax year are deductible by the buyer.
Real Estate Taxes
Applies to homes, land, business buildings, and other types of real estate.
Homeowners frequently pay real property tax bill to escrow account. Deduction timing based on
payment of taxes to governmental body and not escrow account.
When homeowners sell home during year. Deduction is based on proportion of year tax- payer
lived in home no matter who actually pays tax.
First-Time Home Buyer Credit
Refundable first-time home buyer credit for first-time home buyers purchasing homes.
If purchased home in 2008 (on or after April 9), maximum credit was $7,500 and taxpayer must pay
back credit over 15 years.
If purchased home in 2009 (through November 6), maximum credit was $8,000 and taxpayers need
not pay it back.
If purchased November 7, 2009 through April 30, 2010, maximum credit of $8,000 unless a long- time
owner of principal residence then maxi- mum credit of $6,500.
Taxpayers are also eligible for the credit if they enter into a written binding contract to purchase the
home before May 1, 2010, and they close on the purchase of a principal residence before July 1, 2010
Taxpayers who purchase a home from November 7, 2009 through April 30, 2010 but are not first-time
home buyers are still eligible to claim the FTHTC if they are considered to be long-time residents of the
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same principal residence. To qualify as a long-time resident, the taxpayer (and, if married, the
taxpayers spouse) must have owned and used the same principal residence for any 5-consecutive year
period during the 8-year period ending on the date of the purchase of the principal residence that
qualifies for the credit. The FTHTC available to long-time residents is the lesser of (1) 10% of the
purchase price or (2) of $6,500 ($3,250 if married filing separately).
Rental Use of the Home
Tax treatment depends on amount of personal and rental use. The three categories are: 1. Residence
with mini- mal rental use (personal residence)
2. Residence with signifi- cant rental use (vacation home) 3. Nonresidence (rental property)
27 This includes use by a co-owner even when the co-owner pays a usage fee.
To make these determinations, the taxpayer needs to calculate the number of days the rental property
was used for personal use during the year and the number of days the property was rented out during
the year. Rental use includes (1) days when the property is rented out at fair market value and (2) days
spent repairing or maintaining the home for rental use. Days when the home is available for rent, but
not actually rented out, do not count either as personal days or as rental days.
A home is considered to be a residence for tax purposes if the taxpayer uses the home for personal
purposes for more than the greater of 14 days or 10 per- cent of the number of rental days during the
year. For example, if a taxpayer rents her home for 200 days and uses it for personal purposes for 21
days or more, the home is considered to be a residence for tax purposes. If the same taxpayer used the
home for personal purposes for 20 days, the home would not be considered to be a residence for tax
purposes.
Rental Use of the Home
Residence with minimal rental use. Taxpayer lives in the home at least 15 days and rents it 14 days
or fewer.
Exclude all rental income. Dont deduct rental expenses.
Owner is, however, allowed to deduct qualified residence interest and real property taxes on the second
home as itemized deductions.
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discussed below. If the home rental is deemed to be a not-for-profit activity, the loss is subject to the
hobby loss rules in 183.
Losses on Rental Property
Rental Losses
Losses on home rentals in nonresidence use category are passive losses.
Passive loss rules gener- ally limit deductions for losses from passive ac- tivities such as rental to
passive income from other sources.
Passive losses in ex- cess of passive income are suspended and de- ductible against passive income in
the future or when the taxpayer sells the passive activity gen- erating the loss.
Rental real estate exception to passive loss rules Applies to active participants in rental property.
Deduct up to $25,000 of rental real estate loss against ordinary income. $25,000 maximumdeduction phased out by 50 cents for every dollar of AGI over $100,000 (excluding the rental loss
deduction). Fully phased out at $150,000 of AGI.
By definition, a rental activity (includ- ing a second home rental that falls in the nonresidence category)
is considered to be a passive activity. Recall that second homes falling in the significant personal and
rental use category are not passive activities. See 469(j).
A taxpayer who is an active participant in a rental activity may be allowed to deduct up to $25,000 of the
rental loss against nonpassive income. Consistent with a number of tax benefits, the exception amount
for active owners is phased out as income increases: the $25,000 maximum exception amount is phased
out by 50 cents for every dollar the taxpayers adjusted gross income (before considering the rental loss)
exceeds $100,000. Consequently, the entire $25,000 is phased out when the taxpayers adjusted gross
income reaches $150,000.
These losses are suspended until the taxpayer generates passive income or until the taxpayer sells the
property that generated the passive loss. On the sale, in addition to reporting gain or loss from the sale
of the property, the taxpayer will be allowed to deduct suspended passive losses against ordinary
income.
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BUSINESS USE OF THE HOME
To qualify for home office deductions, a taxpayer must use her homeor part of her homeexclusivelyand regularly as either (1) the principal place of business for any of the taxpayers trade or businesses, or
(2) as a place to meet with patients, cli- ents, or customers in the normal course of business.
280A. If taxpayers rent the home they occupy and they meet the requirements for business use of
thehome, they can deduct part of the rent they pay. To determine the amount of the deduction,
multiply the rental payment by the percentage of the home used for business purposes.
This is a facts-and-circumstances determination based upon (a) the total time spent doing work at each
location, (b) the facilities for doing work at each location, and (c) the relative amount of income derived
from each location. By definition, a taxpayers principal place of business also includes the place of
business used by the taxpayer for the administrative or management activities of the taxpayers trade orbusiness if there is no other fixed location of the trade or business where the taxpayer conducts
substantial administrative or management activities of the trade or business.
The clients or patients must visit the taxpayers home in person. Communication through telephone calls
or other types of communi- cation technology does not qualify.
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Rather, this gain is treated as unrecaptured 1250 gain and is subject to a maximum 25 percent tax rate
(see Chapter 10 for detailed discussion of 1250 gain).
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Compute the taxable gain on the sale of a residence and explain the requirements for exclud- ing gain on
the sale.
If they meet ownership and use requirements, married taxpayers may exclude up to $500,000 of
gain on the sale of their principal residence. Single taxpayers may exclude up to $250,000 of gain on the
sale of their principal residence.
To qualify for the exclusion on the sale of real estate, taxpayers must own and use the home as
their principal residence for two of the previous five years preceding the sale.
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The amount of gain eligible for exclusion may be reduced if after December 31, 2008, the
taxpayer uses the home as a vacation home or rental property and then uses the home as a principal
residence before selling it.
Determine the amount of allowable interest expense deductions on loans secured by a residence.
Taxpayers may deduct interest on up to $1,000,000 of acquisition indebtedness of their
principal residence and one other residence.
Taxpayers may deduct interest on up to $100,000 of home-equity indebtedness on their
principal residence and one other residence.
Taxpayers may immediately deduct points paid (discount points and loan origination fees) on
qualifying home mortgages used to acquire the taxpayers principal resi- dence if certain requirements
are met. Qualifying points paid on a loan refinancing are deductible over the life of the loan.
Discuss the deductibility of real property taxes and describe the first-time home buyer credit.
Taxpayers deduct real property taxes when the taxes are paid to the taxing jurisdiction and not
when the taxes are paid to an escrow account.
When a piece of real property is sold during the year, the tax deduction for the property is
allocated to the buyer and seller based on the portion of the year that each held the property no matter
who pays the taxes.
First-time home buyers could claim a refundable credit of $7,500 ($3,750 for married taxpayers
filing separately) for home purchases during 2008 (on or after April 8, 2008), or a refundable credit of
$8,000 ($4,000 for married taxpayers filing separately) for home purchases during 2009 (through
November 6). The credit was phased-out based on taxpayers modified AGI.
Taxpayers acquiring a new home after November 6, 2009 but before May 1, 2010 are eligible for
a maximum refundable first-time home owner credit of $8,000 ($4,000 if married filing separately) if
they did not own a principal residence in the three years prior to the purchase. Taxpayers who owned a
principal residence for a 5 consecutive years during the 8-year period before the new home purchase
are eligible for a maximum first-time home buyers credit of $6,500 ($3,250 if married filing separately).
Taxpayers who claimed the credit for purchases in 2008 must pay it back in 15 equal annual
installments beginning two years after the year in which they purchased the resi- dence that qualified
them for the credit.
Explain the tax issues and consequences associated with rental use of the home, including determining
the deductibility of residential rental real estate losses.
Taxpayers who live in a home for 15 days or more and rent the home out for 14 days or less (a
residence with minimal rental use) do not include gross rental receipts in tax- able income and do not
deduct rental expenses.
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Taxpayers who both reside in and rent out a home for a significant portion of the year (a
residence with significant rental use) include rental revenue in gross income, deduct direct rental
expenses not relating to the home (expenses to obtain tenants), and allocate home-related expenses
between personal use and rental use of the home. They deduct mortgage interest expense and real
property taxes allocated to the rental use of the home as for AGI deductions and the mortgage interest
expense and real property taxes allocated to the personal use of the home as itemized deductions. The
remaining de- ductions allocated to the rental use of the home are deductible in a particular se- quence
and the amount of these deductions cannot exceed rental revenue in excess of direct rental expenses
and rental mortgage interest and real property taxes.
Taxpayers who rent a home with minimal or no personal use (nonresidence) include rental
receipts in income and deduct all rental expenses. In this situation expenses exceeding income are
subject to the passive activity loss rules.
Taxpayers may be able to deduct up to $25,000 of passive loss on their rental home if they are
active participants with respect to the property. This deduction is phased out for taxpayers with
adjusted gross income between $100,000 and $150,000.
Describe the requirements necessary to qualify for home office deductions and compute the deduction
limitations on home office deductions.
To deduct expenses relating to a home office, the taxpayer must use the home exclusively and
regularly for business purposes.
Home-related expenses are allocated between business expenses and personal expenses based
on the size of the office relative to the size of the home.
Mortgage interest and real property taxes allocated to business use of the home are deductible
in full without regard to the income of the business.
Other expenses allocated to the business use of the home are deducted in a particular
sequence. The deduction for these expenses cannot exceed the taxpayers net Schedule C income
(before home office expenses) minus the mortgage interest and real property taxes allocated to
business use of the home.