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Wednesday, May 8, 2024
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Case Studies |
A Solution for the Home Office Deduction
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Case:
Jeffrey and Anita Lewis, both age 65, moved into their home 10 years ago. The housing market has escalated considerably over the past few years due to influx of high-tech industry to their area. Also, the Lewis' home is located in a particularly desirable location. Having purchased the home for $100,000, Jeffrey and Anita have seen it appreciate to a market value exceeding $500,000. A neighbor down the street recently sold his home, which was smaller in square footage and did not have the nice amenities and upgrades, for $495,000. During the 10 years that they lived in the home, Jeffrey and Anita have remodeled the kitchen and bathrooms and have replaced the flooring and window coverings throughout the home. So they know that the market value of their home is probably in the range of $500,000 - $550,000, and it may sell for even more should the housing market continue on its upward course. In fact, in talking with a local realtor, they were told that the house could sell for as high as $600,000 within the next year or so.
Jeffrey is a software engineer and Anita operates a crafts business out of the home. Over 50% of the home is dedicated exclusively to making, storing and showing her crafts for sale. Twice a month, she has a crafts show in which she opens the home to customers to sell her crafts. Since they live in a split-level home, the entire bottom floor is utilized for this purpose and works out ideally. Anita is very creative and seems to have a special gift, as her crafts are well sought after by those in her local area as well as the surrounding communities. Her shows are well attended and she has been able to maintain an excellent and profitable business over a period of several years.
Since a substantial portion of the home is used for Anita's business, their CPA informed them that they would qualify for the home office deduction. This means that Jeffrey and Anita qualify to deduct expenses related to the business use of their home on their personal income tax returns. Such expenses include the properly allocable share of utility costs, insurance, computers and related equipment, and the costs of maintaining the home office. Over the past 10 years, they have taken the appropriate expenses allocable to the business in accordance with the CPA's counsel. Another major expense that Jeffrey and Anita are able to write off on their tax returns is depreciation. As a result of using 50% of the home as a business they have written off $20,000 as depreciation over the past 10 years.
Jeffrey and Anita are considering selling their residence and purchasing a smaller home across town. Jeffrey will be retiring this year and Anita would like to begin winding down her crafts business. Their CPA has told them that the tax rules allow them to exclude $500,000 of gain on the sale of a principal residence. However, since they claimed the home office deduction, any profit or gain attributable to the portion used as the home office will not be eligible for the $500,000 gain exclusion. Therefore, 50%+ of the gain on the sale of the home will be subject to capital gains tax. For example, if the residence sells for $600,000, the gain will be $520,000 ($600,000 sales price less $100,000 basis reduced by $20,000 of depreciation). In their case, $250,000 of the gain would be excludable and $270,000 would be subject to capital gains taxes. Therefore, the federal and state capital gains tax could exceed $54,000, a large tax bite that Jeffrey and Anita would like to avoid.
Question:
Is there some method whereby this onerous capital gains tax could be avoided? Jeffrey and Anita are very philanthropic and are wondering if they could use their home to make a substantial charitable gift to the local Boys and Girls Home. Anita has donated crafts to the Home over the years and they are very devoted to the Home and to its mission. Since they love children and have been unable to have children themselves, they have desired to make such a gift for many years.
Solution:
The Major Gifts Officer at the Home suggested that a solution to the capital gains problem might be to fund a charitable remainder unitrust with an undivided 50% interest in the Home. When the residence was sold, 50% of the proceeds from the sale would be allocable to the unitrust and Jeffrey and Anita would receive the other 50%. For example, if the residence sold for $600,000, sales proceeds of $300,000 would be allocated to the unitrust and the other $300,000 would go to Jeffrey and Anita, who could use it to purchase the smaller home. The Major Gifts Officer states that they must move out of the residence prior to transferring the residence to the trust, in order to avoid "self-dealing" concerns.
Jeffrey and Anita are pleased with this solution and decide to fund a unitrust payable for their lifetimes with the 50% interest in their home. They choose a 7% payout, and therefore, they can expect to receive distributions beginning at $21,000 per year, assuming the home sells for $600,000. They will receive a nice charitable income tax deduction, avoid the capital gains taxes and have the joy of knowing that the Home will receive a substantial gift upon their passing.
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