40.15 Business Income May Limit Home Office Deductions

Even if your home business use satisfies the deduction tests (40.12), deductions for the business portion (40.14) of utilities, maintenance, and insurance costs, as well as depreciation or rent deductions, may not exceed net business income after reducing the tentative profit from Schedule C by allocable mortgage interest, real estate taxes, and casualty deductions. To make sure that deductible expenses do not exceed income, the IRS requires you to use Form 8829. If you do not realize income during the year, no deduction is allowed. For example, you are a full-time writer and use an office in your home. You do not sell any of your work this year or receive any advances or royalties. Therefore, you may not claim a home office deduction for this year. See also the rules for writers and artists earlier in this chapter (40.9).

Part II of Form 8829 limits the deduction of home office expenses to net income derived from office use. You start with the tentative profit from Schedule C. If you sold your home during the year, increase the tentative profit by any net gain (or decrease tentative profit by any net loss) that is allocable to the office area and reported on Schedule D or Form 4797. The following expenses are listed first in Part II of Form 8829 for purposes of applying the income limit: Casualty losses affecting the residence, deductible mortgage interest, and real estate taxes. If there is income remaining after these expenses are subtracted from the Schedule C tentative profit, then home insurance premiums, repair and maintenance expenses for the residence, utility expenses, and rent are claimed against the remaining income. Depreciation is taken into account last, in Part III of Form 8829.

Planning Reminder

Carryover Allowed

Expenses disallowed because of the income limitation may be carried forward and treated as home office expenses in a later tax year (Part IV, Form 8829). The carryover as well as the expenses of the later year are subject to the income limitation of that year. For example, tentative profit for 2012 on Line 29 of Schedule C is $1,000. Expenses allocated to the home office are $2,000. Only $1,000 of the expenses are deductible; $1,000 is carried over to 2013.

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Business expenses not related to the home are deducted on the appropriate lines of Schedule C. For example, a salary paid to a secretary is deducted on Line 26 of Schedule C; the cost of depreciable business equipment used in your home is deducted on Line 13 of Schedule C.

The amount of real estate taxes, mortgage interest, or casualty losses not allocated to home office use may be claimed as itemized deductions on Schedule A.

EXAMPLE

Samuel Brown does sideline business consulting from a home office in his single-family house that he uses exclusively for business for all of 2012. His income in 2012 from consulting services is $12,400. He paid $7,600 for a photocopy machine and a computer, and had office telephone expenses of $600 and office supply costs of $800.

In addition, his home costs are:

Mortgage interest	$10,000
Real estate taxes	4,000
Insurance	1,200
Utilities	1,800

His office space took up 20% of the area of his home, and he figured depreciation allocated to business use of $1,200.

On Schedule C he claims first-year expensing (42.3) for the copier and the computer, and also deducts the office phone costs and supplies. This gives a tentative profit of $3,400 ($12,400 − $9,000) on Line 29, Schedule C.

In Part I of Form 8829, he lists the total area of the home and the area used for business, showing 20% business use.

In Part II, he enters the home costs listed above. We have taken only the relevant lines of the Form 8829 as an illustration. Samuel Brown’s Form 8829 is on page 653.

No depreciation is deductible because there is no remaining business income and excess home office expenses may not generate a loss deduction. The depreciation is carried over to 2013. Home office expenses of $3,400 from Lines 14 and 26 are deducted on Line 30, Schedule C.

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Planning Reminder

Substantiating the Sideline Business

In claiming home office expenses of a sideline business, it is important to be ready to prove that you are actually in business (40.10). In the case cited in the Example in 40.16, the Tax Court held that the doctor’s personal efforts in managing the six units for tenants were sufficiently systematic and continuous to put him in the rental real estate business. In some cases, the rental of even a single piece of real property may be a business if additional services are provided such as cleaning or maid service.

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