Archive for July, 2013|Monthly archive page

Home Office Part I – New Option for 2013

Originally published in the Cedar Street Times

July 26, 2013

In January, the IRS issued Revenue Procedure 2013-13 which discusses a new option for calculating the home office deduction.  (You may want to clip this article and put it in your tax file as a reminder.) Instead of tracking the actual expenses of operating your home office such as water, utilities, garbage, repairs and maintenance, depreciation, etc., you can now elect a safe harbor $5 per square foot of qualified office space, up to 300 square feet ($1,500).  It is kind of like taking a standard mileage deduction on your car instead of tracking gas and repair receipts, and calculating depreciation expense.  Unlike vehicles, however, you can switch methods back and forth from one year to the next.

There are a few interesting provisions that will make it a good option for some people, and a bad option for others.  In other words, when preparing your return you will need to analyze the short and long term impacts, and determine which method is best each year. Since the $5 per square foot figure is not adjusted by region or for inflation, individuals living in high cost states like California are at a disadvantage.

If there is more than one person in the house, such as a spouse or roommate, they can each use the safe harbor as long as they are not counting the same space.  If one person has more than one office in the home for more than one business, the person can either use actual expenses for all the businesses, or the person must use the safe harbor for all the businesses.  However, the maximum deduction allowed is still $1,500 for all the businesses in the home combined, which may have to be allocated pro rata to the businesses based on square footage used by each. If one person has qualified home offices in more than one home, the person can use the safe harbor for one home, but must use actual expenses for the other home.

When claiming the safe harbor deduction, you are allowed to take your property taxes and mortgage interest in full as itemized deductions on Schedule A as well as claiming the safe harbor deduction.  On the surface this sounds like a plus, but for self-employed individuals you are effectively converting expenses that used to be on your Schedule C reducing self-employment taxes to itemized deductions which do not reduce self-employment taxes, and perhaps do not even reduce income taxes if you do not itemize.

Another big difference when claiming the safe harbor deduction is that no depreciation expense is allowed to be taken.  Traditionally, any depreciation expense taken on your home is required to be recaptured at the time you sell your house, and you must pay tax on it.  Even the section 121 exclusion ($250,000 tax-free gain for single/$500,000 for married couples) when living in the house for two out of the last five years will not exempt you from recapture taxes.  Occasionally that can produce negative results, but it is usually helpful because it often helps people avoid income AND self-employment tax which are typically higher than recapture rates.  Nonetheless, I regularly see tax returns where no depreciation was taken on a home office, to “avoid recapture.”  This is incorrect as recapture rules require you to recapture any depreciation “allowed or allowable.”  It does not matter whether you took the deduction or not, you are technically still on the hook for the recapture.

One other notable exception in the 15 pages of new rules explaining the safe harbor is that carryover expenses are not allowed for safe harbor years.  Ordinarily, if your business produces a loss, you are not allowed to create a bigger loss from business use of home expenses with the exception of the portion of mortgage interest, property taxes, or casualty losses which would have been allowed as itemized deductions even if you had no business.  The rest of the expenses get carried over to future years until you make a profit and can use the losses.  Using the safe harbor, any loss generated by the safe harbor disappears forever.  You would be better off in these years using actual expenses in order to preserve the losses for the future.

At the end of the day, you might as well just continue to track the actual expenses, and let your tax professional figure out which method will give you the best benefit each year.

In two weeks, we will go over the basic requirements in order to claim a home office deduction.

Prior articles are republished on my website at www.tlongcpa.com/blog.

IRS Circular 230 Notice: To the extent this article concerns tax matters, it is not intended to be used and cannot be used by a taxpayer for the purpose of avoiding penalties that may be imposed by law.

Travis H. Long, CPA is located at 706-B Forest Avenue, PG, 93950 and focuses on trust, estate, individual, and business taxation. He can be reached at 831-333-1041.

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Rental Property Outside of CA: LLC Options and Issues – Part II

Originally published in the Cedar Street Times

July 12, 2013

Two weeks ago, I discussed that LLCs are a popular choice for holding rental property, but that it certainly comes at a cost in California when you consider a minimum $800 annual franchise tax, the cost of filing another tax return each year, having to maintain better accounting records, as well as the initial costs to set it all up.  I also advised that if you do setup an LLC, you want to utilize an attorney to set things up instead of a do-it-yourself online approach.  I have seen plenty of problems from people using the latter method.  It is pretty easy to jeopardize the liability protections of the LLC if you do not have competent legal advice.  Since liability protection is one of the main reasons you go to all this continued expense and trouble, you might want to consider the old adage: penny-wise, pound-foolish.

Two weeks ago, I also raised the question and left readers pondering about whether you could save the minimum $800 a year tax by setting up your LLC in another state, which of course would be a natural inclination anyway, if the property is located in another state.

Many Californians are already in this boat, and I would say quite a number of them are unaware that even if they have a non-California LLC holding non-California rental property, they are generally required to register in California and pay California the minimum $800 franchise tax.  The franchise tax is levied on you if you are considered doing business in California.  So how is your rental property in Arizona, for example, that is held in an Arizona LLC (that maybe even loses money every year) considered doing business in California and subject to a minimum $800 California tax?

California’s position is that the mere fact that a managing member of the LLC lives in California, is enough to constitute that the LLC is doing business in California.  More specifically, they say that if you have more than one member, LLCs are taxed under partnership law unless you elect to be treated as a corporation.  Partnership law says that the activities of the partnership flow through and are attributed to the partners, and that the partners are therefore, by statute, doing business.  If they reside in California, then they are doing business while in California, thus requiring registration of the LLC in California and payment of the $800 minimum franchise tax (and filing of a tax return).  Limited partners also have statutory rights to participate so California is not letting them off the hook either.

Single member LLCs (a husband and wife are treated as one member in California) are disregarded entities for tax purposes and are not taxed as partnerships or corporations, but are reported directly on your personal tax returns.  For single member LLCs and corporations California will look to facts and circumstances.  If you could somehow build a case that your LLC had absolutely no connections with California (such as tax preparation, bank accounts, etc.) and that every time any decision needed to be made with regard to managing your property or LLC, you were out of the state of California (and not on your living room telephone), you might have a shot at not “doing business” in California! It is an extremely difficult threshold, and taxpayers have been losing case after case in court over this issue.

California has also put into place a steep new penalty for anyone failing to register.  In addition to the minimum $800 franchise tax, they are now assessing a $2,000 penalty plus interest for every year you have failed to register.  At about, $3,000 a year, that adds up quickly. Generally, California does not go back to assess past delinquencies if you start reporting before they discover you.  The internet and increased sharing of information between state taxing authorities is making this much easier to detect.  So make haste and get compliant if you are not already.

Prior articles are republished on my website at www.tlongcpa.com/blog.

IRS Circular 230 Notice: To the extent this article concerns tax matters, it is not intended to be used and cannot be used by a taxpayer for the purpose of avoiding penalties that may be imposed by law.

Travis H. Long, CPA is located at 706-B Forest Avenue, PG, 93950 and focuses on trust, estate, individual, and business taxation. He can be reached at 831-333-1041.