Are There Problems with the Home Office Deduction for Your S Corporation?

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In a recent email, I talked about the 5 biggest mistakes that I see people making on their tax returns. These weren’t problems that you’ll see in the regular blogs floating around the Internet. You know, the same old things – make sure you report all your 1099s, make sure you sign your return, make sure the addition in right, don’t take the home office deduction because it’s a red flag…

Wait a minute!

The home office deduction is NOT a red flag.

Sometimes I feel like beating my head against my desk when I hear people say it is. The law was clarified in 2004. That was 14 years ago! Since then, the home office deduction has become much easier to take. In fact, the IRS made it even easier to take the home office deduction FIVE YEARS ago in 2013. I’m not a huge fan of the simplified version, but I think it proves that the IRS was trying to make it easier, not harder for you to take the deduction.

And even if you’re still freaked out by it, even though it’s clearly very old news that the IRS considers it a red flag, just consider WHERE you take the deduction on an S Corp. It’s a rental deduction. The IRS doesn’t even know you have a home office. It could be a rental anywhere.

I received a follow-up question to that first of five red flags. Here’s the question:

“If you take the rental deduction on the S corp, how is the amount determined, and where is the offsetting income, on the personal return of the shareholder?  If you claim rental income on your home to the extent of the deduction on the corporation, aren’t you then just shifting income and subjecting the home office deduction to depreciation recapture?”

Let’s start with the first question. How do you determine the rental income, where does it offset income and how does it report on the personal return?

The amount of rental income is the actual calculation for indirect expenses for the home office use. For example, if 200 square feet of a 2000 square foot house is used for business purposes, then you have 10% for business usage.

That 10% business usage percentage is then applied to all indirect costs like mortgage interest, property tax, rent (if applicable), utilities, HOA dues and the like. If you have direct expenses for the space like new flooring, remodeling costs, etc., those are 100% deductible. Add up the total business expenses and that is the amount that the company reimburses you for personal expenses. You also have the option to depreciate 10% of your home basis for the home office. You don’t have to do that. It’s an option.

The total rental expense reported on your Form 1120S (using the example of an S Corp) just like any other expense.

This then flows through to the K-1 which shows your net income or loss from the business and is reported as a net number on your individual income tax Form 1040.

The second part of the question asked about offsetting the “income” received from home office from the S-Corp payment to you. I’m not quite sure I understand that question. You are being reimbursed for expenses, not being paid rent. So there is no income from the home office.

If you claim a partial deprecation expense on the home office portion, it will indeed need to be recaptured on the sale of the home. You do not recapture rental expenses when you sell.

If you want a follow-up discussion on depreciation or any other blog topic, come on over to Facebook to join “Diane Kennedy’s US Tax Group.” You’ll find other business owners and real estate investors there who are looking for ways to make use of new tax strategies to pay a whole lot less in tax.

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