IRS Addresses Interplay of State Tax Limitation and Home Office Deduction

(Parker Tax Publishing April 2019)

The IRS Office of Chief Counsel advised that, if a taxpayer's total individual state and local taxes meet or exceed the $10,000 limitation of Code Sec. 164(b)(6), or if the taxpayer chooses to take the standard deduction instead of itemizing deductions, none of the taxpayer's state and local taxes relating to the taxpayer's business use of the home are included as expenses under Code Sec. 280A(b). However, to the extent the excess of the taxpayer's state and local taxes that exceed $10,000 are attributable to the taxpayer's business, such expenses would be deductible under Code Sec. 280A(c), subject to the gross income limitation under Code Sec. 280A(c)(5). PMTA 2019-1.

Limitation on Home Office Deductions

Under Code Sec. 280A(a), individuals and S corporations cannot take any deduction for expenses related to a dwelling unit used as a taxpayer's residence during the tax year unless another provision of Code Sec. 280A specifically allows the deduction. Code Sec. 280A(b) excepts from Code Sec. 280A(a) deductions allowable to the taxpayer without regard to the deduction's connection with the taxpayer's trade, business, or income-producing activity (i.e., mortgage interest, certain taxes, certain casualty losses that are allowable to individuals under other provisions of the Internal Revenue Code).

Observation: Code Sec. 280A(b) is essentially a parity provision that prevents Code Sec. 280A(a) from limiting home expenses that would otherwise be allowable to individuals who are not using part of their home for trade, business, or other income-producing activity.

However, the provisions in Code Sec. 280A(c)(1) through Code Sec. 280A(c)(4) allow deductions for certain expenses related to certain business or rental uses of a dwelling unit, subject to the following gross income limitation: Gross income from the trade, business, or rental, MINUS deductions identified under Code Sec. 280A(b), MINUS deductions not incurred in connection with the dwelling unit used as a residence (e.g., advertising, office supplies) = Gross income from which the taxpayer can deduct Code Sec. 280A(c) expenses.

Deductions identified under Code Sec. 280A(b), as well as expenses that are not incurred in connection with the use of the dwelling unit as a residence (e.g., advertising and office supplies) are not limited under Code Sec. 280A(c)(5).

If, and only to the extent to which, any amount remains in the calculation, above, a taxpayer may take deductions identified under Code Sec. 280A(c) in the current year. Any expenses not allowed due to the gross income limitation in Code Sec. 280A(c)(5) are carried over to future years. If the taxpayer never has sufficient gross income, the deductions are ultimately lost.

Tax Deduction Limitation for 2018 through 2025

The Tax Cuts and Jobs Act added Code Sec. 164(b)(6). Code Sec. 164(b)(6) limits an individual's itemized deduction to $10,000 ($5,000 in the case of a married individual filing a separate return) for the aggregate of: (1) state and local real and personal property taxes not paid or accrued in carrying on a trade or business or an activity described in Code Sec. 212; (2) state and local income, war profits, and excess profits taxes not paid or accrued in carrying on a trade or business or an activity described in Code Sec. 212; and (3) sales taxes deducted in lieu of income taxes paid or accrued during the taxable year. These limitations apply to tax years beginning after December 31, 2017, and before January 1, 2026, but they do not apply to any taxes paid or accrued in carrying on a trade or business or other activity described in Code Sec. 212.

Interplay Between the Home Office Deduction and the Tax Deduction Limitation

Because the limitation under Code Sec. 164(b)(6) is calculated by combining the taxpayer's state and local taxes, a taxpayer using a portion of his or her residence for an income-producing purpose must first calculate the percentage of the business use of the home and then apply that percentage to the total amount of state and local taxes paid in connection with the ownership of that home to determine the portion of the state and local taxes attributable to the business use of the home and the portion attributable to the individual use of the home. Once that determination is made, the taxpayer combines the individual use portion with the taxpayer's other individual state and local taxes paid (income taxes or sales taxes, personal property taxes, war profits, excess profits taxes, and other real property taxes) to determine the taxpayer's total individual state and local taxes. If that amount meets or exceeds the $10,000 limitation under Code Sec. 164(b)(6), then the taxpayer does not have any additional taxes that would be deductible under Code Sec. 164(b)(6). In that case, the entire business portion of the state and local taxes would be considered a Code Sec. 280A(c) expense subject to the gross income limitation under Code Sec. 280A(c)(5).

Similarly, if a taxpayer opts to take the standard deduction in lieu of itemizing deductions, then the taxpayer is not entitled to any deduction under Code Sec. 164(b)(6), and the entire business portion of the state and local taxes would be considered a Code Sec. 280A(c) expense subject to the gross income limitation under Code Sec. 280A(c)(5).

In the case of a taxpayer whose individual state and local taxes do not meet or exceed the $10,000 limitation, if that taxpayer had state and local taxes attributable to the income-producing activity, the taxpayer could deduct as a Code Sec. 280A(b) expense the amount of state and local taxes attributable to the business, up to the difference between the $10,000 limitation and the taxpayer's total individual taxes under Code Sec. 164. The rest of the state and local taxes attributable to the business can be expensed under Code Sec. 280A(c), subject to the gross income limitation.

Example: Robert has a home that he rents for 1/3 of the year. For 2018, his real estate taxes on the home were $12,000 and he paid $5,000 in state and local income taxes. The real estate taxes are allocated $8,000 to Robert's use of the home and $4,000 to the rental use of the home. Robert's total individual state and local taxes paid equal $13,000 (i.e., $8,000 individual real estate taxes plus $5,000 state and local income taxes). Robert's individual itemized deduction for state and local taxes is limited to $10,000. Because his actual individual state and local taxes exceed the $10,000 limit, Robert's $4,000 of real estate taxes attributable to the rental are expenses under Code Sec. 280A(c) and are subject to the gross income limitation under Code Sec. 280A(c)(5). None of Robert's real estate taxes attributable to the rental use of his home are expenses under Code Sec. 280A(b).

Example: Assume the same facts as the example above, except that Robert rents the home for 2/3 of the year. Thus, the real estate taxes are allocated $4,000 to Robert's use of the home and $8,000 to the rental use of the home. Robert also paid $12,000 in mortgage interest on the home but had no other itemized deductions. Therefore, Robert's total individual state and local taxes equal $9,000 ($4,000 individual real estate taxes plus $5,000 state and local income taxes) and Robert's total individual itemized deductions equal $13,000 ($9,000 in state and local taxes plus $4,000 in mortgage interest (1/3 of the total mortgage interest paid)). Robert's itemized deductions exceed the standard deduction amount of $12,000, so he chooses to itemize his deductions. Robert's total individual state and local taxes do not meet or exceed the $10,000 limitation. If Robert had not rented his home, he would have been able to deduct an additional $1,000 of the real estate taxes, which are currently attributable to the business use of the home, as individual state and local taxes under Code Sec. 164(b)(6). As a result, Robert can include as a Code Sec. 280A(b) expense the $1,000 (the difference between the $10,000 limitation and $9,000 (Robert's total individual state and local taxes)), and such amount will not be subject to the gross income limitation of Code Sec. 280A(c)(5). The rest of Robert's real estate taxes attributable to the rental use of the home ($7,000) are Code Sec. 280A(c) expenses and are subject to the gross income limitation under Code Sec. 280A(c)(5).

Example: The facts are the same as the above example, except that Robert did not pay any mortgage interest on the home. Thus, Robert had a total of $9,000 in individual itemized deductions and opted to take the standard deduction of $12,000 instead of itemizing his deductions. Because Robert opted to take the standard deduction in lieu of itemized deductions, there is no amount of state and local taxes that would have otherwise been allowable to Robert under Code Sec. 164 but for the rental use of the home. As such, all of the real estate taxes attributable to the rental use of the home are Code Sec. 280A(c) expenses and are subject to the gross income limitation of Code Sec. 280A(c)(5).

Observation: The methodology, above, also applies when applying the rules in Code Sec. 280A to other itemized deductions available to individuals (i.e., mortgage interest and casualty losses).

For a discussion of the $10,000 tax deduction limitation, see Parker Tax ¶83,115 and ¶83,125. For a discussion of the home office deduction, see Parker Tax ¶85,505.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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