Home office deductions warrant consideration

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The expense of using a portion of your home "exclusively" for business purposes is, as everyone knows, tax deductible.

The expense of using a portion of your home "exclusively" forbusiness purposes is, as everyone knows, tax deductible.

Changes to the tax laws that became effective in 1999, significantlyincreased the number of veterinarians who were eligible to deduct thosehome office expenses.

Not too surprisingly, many veterinarians who qualify for a home officededuction usually take full advantage of it. Remember, however, under thetax rules, the home office deduction reduces that mount of gain that canbe ignored when your residence is eventually sold or exchanged.

Our tax law contains a tax deduction for expenses associated with a homeoffice if that office is exclusively used on a regular basis as the principalplace of business for any veterinarian. The Internal Revenue Service (IRS)created a test in a 1994 Revenue Ruling for comparing the relative importancefor the work done at each location that is part of the veterinary practice.

If that comparison did not identify your principal place of business,the IRS would then compare the amount of time spent at each location. Thisruling opened up the door to many contractors, plumbers, electricians, salespersonswhose work was performed outside the home, allowing them to meet the testand deduct the expenses associated with a home office.

Further expansion

The Taxpayer Relief Act of 1997 (TRA) further expanded the definitionof a principal place of business. Today, an office located in the home qualifiesas a principal place of business for a veterinarian if:

* The office is used by a veterinarian for the administrativeor management activities of his or her veterinary practice; and

* There is no other fixed location of that practice where theveterinarian conducts substantial administrative activities.

Thus, as long as the home office is used by a veterinarian for administrativeor management activities, and they do not conduct substantial administrativeor management activities at another fixed location, it qualifies as a principalplace of business-and the associated tax deductions for home office expenses.

In recent years, few veterinarians have been deterred from claiming atax deduction for the portion of expenses such as home mortgage interestand property taxes, insurance, maintenance and utilities that are associatedwith the use of a home office. Even a depreciation allowance for the portionof the residence used as a home office can be deducted. Therein lies onereason why many veterinarians may wish to ignore the home office expensededuction.

Downside

The same tax law changes that opened up the home office deduction tomore taxpayers (TRA), also expanded the amount of gain resulting from thesale of a residence that could be excluded from income or ignored by droppingthe age 55 or older restrictions. Today, any taxpayer, regardless of age,may exclude from taxable income the first $250,000 ($500,000 for marriedcouples filing joint returns) of gain from the sale or exchange of a principalresidence.

In order to qualify for this exclusion, however, the property must beowned and used by the taxpayer as a residence for periods aggregating twoor more years during the five-year period ending on the date of sale.

Unfortunately, a veterinarian who claims a home office deduction willnot be able to exclude the entire amount of gain on the sale of his or herpersonal residence. First, gain must be recognized for the depreciationdeductions taken on a home office. Second, the entire portion of the homeused as a home office is ineligible for exclusion if it isn't used as aprincipal residence for two out of every five years before the sale.

In the past, many veterinarians avoided depreciation recapture by shuttingdown the home office and using it as a residence before selling the home.Now, after TRA, the portion of gain attributable to depreciation must berecognized even if the entire residence is converted to personal use beforethe sale.

Fortunately, the required recognition of previously taken (or allowable)depreciation deductions shouldn't prevent you from claiming a home officededuction.

Depreciation taken on a home office is, of course, deducted against ordinary,fully-taxable income. For self-employed veterinarians, the deduction isallowed when computing net earnings from self-employment, reducing boththe amount of taxable income and the amount of those onerous self-employmenttaxes.

Under our rules, gain resulting from the recapture or payback of straight-linedepreciation (the method required for most buildings and portions of buildings)is considered to be "unrecaptured" Section 1250 gain. That Section1250 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 only25 percent while today's depreciation deductions may offset income thatis taxed at a 28 percent tax rate.

Unquestionable pitfall

The most serious problem for those veterinarians claiming both a homeoffice deduction and an exclusion of gain on the sale of a principal residencearises because of that "two-out-of-five-year" use requirement.Any portion of the home used exclusively as a home office cannot, at thesame time, be used as a principal residence.

As a result, if a portion of the home is used as a home office for morethan three years in the five-year period ending on the date of sale, thetwo-out-of-five-year use requirement is considered "not met" forthat part of the house. The entire amount of gain attributable to that partof the house, not just depreciation, must be included in income.

Tax strategy = savings

Many veterinarians may want to forego the home office deduction entirely.This strategy is particularly advisable for veterinarians with relativelyfew home office expenses and with a large, built-in gain on a principalresidence that they are certain they will sell in the near future. The taxsavings from claiming a home office deduction may not be sufficient to offsetthe loss of part of the home sale proceeds exclusion (Section 121).

Of course, taking full advantage of the home office deduction is stilladvisable for some veterinarians-even if they are contemplating sellingtheir principal residence. Anyone with a large amount of home office expensesmay be better off taking an immediate deduction even though they have torecognize that gain in the future. The savings in self-employment taxesalone may make the immediate deduction of home office expenses the mostadvisable course of action. The continued deduction of home office expensesis usually advisable if the expected gain on the sale of the home is small.

A "two on and three off" strategy involves using the officefor personal purposes (thus disqualifying it as a principal place of business)for two years followed by using it exclusively as a home office in threeyears. This strategy will ensure that the portion of a principal residenceused as a home office will always qualify for gain exclusion.

The price of ensuring that the two-out-of-five year use requirement ismet and the entire home qualifies as a principal residence at all timesis the loss of a home office education two out of every five years. This"cost" may be advisable for veterinarians with large, built-ingain on their residence who contemplate a sale of the residence at somepoint in the future, but who may be unsure of the timing of the sale.

Obviously, the "two on and three off" strategy should not beused by veterinarians who have no intention of selling their principal residencein the foreseeable future. Those veterinarians should continue to take fulladvantage of the home office deduction. If they are forced to change theirprincipal residence because of a change in employment or health, that two-yearuse requirement does not apply.

Benefits to ignoring deduction

By now it should be obvious that there is more than one side to the incometax deductions for home office expenses. Proper planning should considermore than the impact that those deductions will have on this year's taxbill.

As always, check with your tax advisor about your particular situationto make sure you satisfy all IRS rules and regulations for deductions.

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