SALT $10,000 Limit Complicates Home Office Deduction
The Tax Cuts and Jobs Act’s unpopular $10,000 limitation on the deduction for state and local taxes are having a ripple effect on other tax computations. The provision makes taxpayers combine all of their state and local taxes paid–including state income taxes, real property taxes, personal property taxes, and sales taxes–and then only allows up to $10,000 as an itemized deduction.
How the SALT limit affects home office deductions is the subject of new IRS guidance which explains how to allocate the deductions between individual and business use. The SALT limitation does not apply to taxes incurred in a taxpayer’s business, including property taxes allocable to a home office. So, self-employed taxpayers can still take SALT deductions for expenses allocable to their business use of a home. However, those types of expenses are subject to a different limitation—the income from the business. Taxpayers cannot take a home office deduction in excess of the income earned by the business. This allocation has become a more complicated process which, thankfully, has been illustrated by the IRS in three examples, shown below.
Taxpayers Hitting the $10,000 Limit
To get started, a taxpayer with a home office must first calculate the percentage of the business use of the home and then apply that percentage to the total amount of property taxes paid for the entire home.
For example, if the home office was 10% of the house and total property taxes were $8,000, $800 would be the amount of property taxes allocable to the business. Once that determination is made, the taxpayer combines the individual use portion $7,200 ($8,000 – $800) with the taxpayer’s other individual state and local taxes paid to determine the taxpayer’s total individual state and local taxes. If that amount exceeds the $10,000 SALT limitation, then the taxpayer does not have any additional taxes that would be deductible as an individual itemized deduction.
The $800 business portion of the property tax would be treated as a home office deduction and would be subject to the business income limitation. If a taxpayer takes the standard deduction instead of itemizing, the taxpayer gets no individual itemized deduction for property taxes and the $800 business portion is allowed but is subject to the business income limitation.
Taxpayers Under the $10,000 Limit
If a taxpayer’s individual state and local taxes do not exceed the $10,000 limitation, the taxpayer can deduct 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. The rest of the state and local taxes attributable to the business would be taken as home office deductions and would be subject to the business income limitation.
The process is abstract and is best illustrated with the following IRS examples:
Example 1: Tom has a home that he rents out for 1/3 of the year. His real estate taxes on the home are $12,000. He also pays $5,000 in state and local income taxes. The real estate taxes are allocated $8,000 to the individual use of the home and $4,000 to the rental use of the home. Tom’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). Because his actual individual state and local taxes exceed the $10,000 limit, the $4,000 of real estate taxes attributable to the rental are deducted as home office expenses subject to the business income limitation.
Example 2: The facts are the same as Example 1, except that Tom rents the home for 2/3 of the year. Now the real estate taxes are allocated $4,000 to the individual use of the home and $8,000 to the rental use of the home. Tom also paid $12,000 in mortgage interest on the home but had no other itemized deductions. Therefore, his total individual state and local taxes equal $9,000 ($4,000 individual real estate taxes plus $5,000 state and local income taxes) and his 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)).
Tom’s itemized deductions exceed the $12,000 standard deduction, so he chooses to itemize. Tom’s total individual state and local taxes do not exceed the $10,000 limit. If he had not rented his home, Tom 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. In this situation, Tom can treat the $1,000 difference between the $10,000 limitation and the $9,000 total individual state and local taxes and that amount will not be subject to the business income limit. The rest of his real estate taxes from rental use, the $7,000, are home office expenses subject to the business income limitation.
Example 3: The facts are the same as Example 2, except that Tom did not pay any mortgage interest on the home. He had a total of $9,000 in individual itemized deductions and opted to take the standard deduction of $12,000 instead of itemizing. In this situation, all of the real estate taxes attributable to the rental use of the home ($8,000) are treated as home office expenses subject to the business income limit.
When filing taxes, you can’t just be concerned with the amount of the deductions, but you also must put them in the right category and apply the appropriate limitations. As you can see, this is a complex process which has become more convoluted with the passage of the Tax Cuts and Jobs Act. It is important to consult with your Frazier & Deeter tax advisor to make sure you are correctly applying all of these rules and getting the maximum deduction available.