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Operating your single-owner business as an S corporation has a variety of tax advantages. One way to ensure your tax advantages is to have your company reimburse you for the costs of keeping a home office. This tax savings strategy enables you to:
- Convert the mileage from your commute into business mileage, thus increasing your vehicle deductions;
- Consider a portion of your home expenses to be business expenses; and
- Avoid home office audit risks on your tax return.
And, here’s even more good news when you employ this strategy—you never pay back those tax savings, even when you sell your house. Of course, in order to reap these benefits, you will have to make sure you follow the proper procedures (including documentation) regarding the office in your home. Many of these apply even if you operate your business under an entity structure other than S corporation.
Getting Reimbursed for Your Office
By tax law, S corporation owners are able to make deductions on home office expenses, and there’s more than one way you can go about doing so. However, the best way is to have your corporation reimburse you for the employee-business expenses you incur from having an office at your home.[1]
Let’s just look at the basics for a moment. When you create an office in your home, you have switched a portion of your house to business use from personal use. So, on your taxes, part of your home is considered a business asset. If, as an example, you used 1/3 of your house for office space, then 1/3 would be a business asset and 2/3 would be a personal asset.
Office Location Makes a Difference
Did you know that where you locate the office in your home can make a big difference on your tax savings? In fact, in the right location, your office is eligible for a $250,000/$500,000 home profit exclusion from taxes. This exclusion applies when you eventually sell your home. That’s right—how you locate your office now can affect tax savings at the time of sale. Specifically, you get a break on taxes for up to $250,000 (filing singly) or $500,000 (filing jointly) of profits on the sale of your personal residence.[2]
What does the business portion of your home have to do with this? Well, you generally have two possible scenarios:[3]
- The office is inside the walls of your home. If this is the case, you’re in a good position because the home sale profit exclusion applies to both the business and personal portions of your residence. The only exception to this is depreciation recapture (which will be further explained).
- The office is outside the walls of your home. An example of this would be an office located in a detached garage, guest house, or some other separate structure. In this situation, you’ll need to do a little more planning in order to get the best possible result. The tax exclusion will only apply to the residential part of your property. The sale of the business part will generate taxable business gains, as well as recapture on depreciation. However, as you’ll see discussed below, you can use a Section 1031 exchange to get out of those taxes.
Anytime you sell a house, you have a recapture tax for the depreciation you claimed. Regardless of the location of your home office, the home sale profit exclusion does not get rid of the recapture.[4] Before you start to feel gloomy about this, know that depreciation still gives you an advantage, even with the recapture tax, and here’s why:
- You defer this payment until the year of sale, and
- It’s possible for your depreciation deduction to be greater than (up to 36.9 percent rates) your recapture tax rate (up to 25 percent).[5]
Of course, it would be even better to just get rid of that recapture tax all together, wouldn’t it? Well, you can.
Making a 1031 Exchange
For any business gain you have left that is not covered by the profit exclusion you can make a like-kind, Section 1031 exchange. In fact, the IRS has provided guidance specifically on how to combine the home sale profit exclusion with the 1031 exchange for selling a house with an office.[6] Section 1031 will not dispose of your tax. What it does instead is defers it. But, here’s the really nifty bit, you can keep on making 1031 exchanges with every home sale and deferring that payment for the rest of your life. Then, the home goes up to fair market value and your taxable gains disappear.
The most important thing you need to know about making the 1031 exchange is that you must hire a professional intermediary to handle the monetary exchange. Don’t worry—you’ll spend less on an intermediary than what you would have paid in taxes, and a professional will ensure that you go through the process correctly.
Here’s how Section 1031 works when your office is inside your home (this example comes from the IRS):[7]
- You bought your home for $210,000 and split it into 1/3 business use and 2/3 personal use.
- Because you split the basis between business and personal, you have a business use basis of $70,000 and a personal use basis of $140,000.
- With a $30,000 depreciation for your office, that leaves a business use basis of $40,000 (reduced from $70,000).
- When you sell your home, it will split into a business portion and a personal portion. So, if you sell the house for $360,000, then you have sale prices of $120,000 for the business part and $240,000 for the personal part.
- You qualify for the full $250,000 Section 121 exclusion (single filing).
- Determine the gain on both parts of the home. In this example it’s $80,000 for business ($120,000 – $40,000) and $100,000 for personal ($240,000 – $140,000).
- Apply the profit exclusion to both parts (personal first). Don’t include recapture. Applying the $250,000 exclusion to your $100,000 personal gain gives you zero taxable gains, and you are left with $150,000 of profit exclusion. This remainder is applied to the business portion, except for your $30,000 of depreciation recapture.
- Finally, you defer the $30,000 using a Section 1031 exchange to acquire a new house with a new home office and watch the taxes disappear!
And, what about when your office is in a structure outside of the main residence? The example above changes a little bit. Here’s how it all works out:
- Determine the gain on both parts of the home. This is done in exactly the same way as it’s calculated in steps 1-6 above.
- Apply the profit exclusion to both parts of your residence. This step, however, is different from above. In this case, the exclusion does not apply to the business portion, which is located outside the walls of your home. You still get $0 in personal gain, but business gains will come to $50,000 capital gains and $30,000 depreciation recapture (determined by the $80,000 in business gains calculated above).
- Here’s the good news. You can still use a 1031 exchange to defer both the $50,000 in capital gains and the $30,000 in depreciation recapture.
It’s pretty clear that converting part of your home into an office for your S corporation makes good financial sense. If you don’t have an appropriate space inside your home, you can make an office in a detached structure. The math works out a bit differently, but you can still save big on taxes when you plan correctly.