Purchasing a residential home to use as office and then converting to personal use

[klw085]

Hello,

Let's assume that I am a high paid consultant working as a sole proprietorship.  With Covid remote work and my kids being at home it's been quite crowded.  Would it be possible to purchase another house to use solely for business.  Obtain a mortgage etc.  But then pay off that mortgage using my business income so that the mortgage would come out of my profits?

For simplicity's sake suppose I didn't even bother to take depreciation on this property.  In a year I then convert this home to personal use.  What exactly would I owe the IRS at that point?  I didn't take depreciation on this property.  Eventually when I sold it I would owe capital gains on any appreciation.  But the initial payment was done with pre-tax income from my business.

This seems like it shouldn't be possible?

[klw085]

Never mind.  I forgot that I could not take a deduction on mortgage principle.

That said, depreciation recapture on property is 25%?  So in theory I could buy a home to use as an office.  Could I take bonus depreciation or at least section 179 depreciation (assume the home is around 1 million).  Assume my tax bracket is around 40%.

I could then after a year or so convert to personal use.  Depreciation recapture would then tax me at 25%.  This would result in a 15% savings?   Again, am I missing something?

[Critter-3 · Accepted solution]

Depreciation  is required not an option and you cannot take the 179 or bonus depreciation on a piece of real estate  and you don't depreciate land.  This  is how the principal portion of the mortgage payment is accounted for legally on a tax return.  The fact that you will or do  pay off the loan faster than you take depreciation is immaterial.   

And the depreciation recapture happens when you eventually sell the home and not on the date of conversion to personal use.  May I suggest you seek local professional guidance so you make the right decision for you... at your estimated income level you can afford to get educated.   Of course who knows what the congress and president will do in the future ... all you can use to plan is the current laws. 

[klw085]

I see my error now. Thanks. That said if I were to purchase a residential home to use as an office I assume I would take the 27.5 year depreciation for residential property Rather than commercial?

[Critter-3]

Wrong again ... since you are using it for a business it is NOT residential use so you must use the commercial depreciation tables and the longer time frame of 39 years ... this is actually in your favor.  

[Carl]

It would seem that your education on how taxes work for your specific needs is a bit skewed.

For starters, I would fully expect declaring an entire residential property as a home office would raise eyebrows at the IRS. However, do the local laws and ordinances of the location where the property is at permit you to classify the property as your primary place of business? If so, then after running that change through the local government authorities and getting it approved and reclassified as such, declaring the entire property as the primary physical location of your business for federal and state tax purposes would not be an issue. However, the classification and permitting cost to do that for only a year or less would probably not be worth it financially. It would most likely be significantly cheaper and make more sense to just rent office space in a commercial building intended for exactly that.

I didn't take depreciation on this property.

Wait a minute. You started your post with, "Let's assume that I am a high paid consultant working as a sole proprietorship." indicating this is something you were considering. Now the above statement seems to indicate that this is something you have already "in fact" done. If this is something you've already done without having done your homework first, then you're stuck with what you got unfortunately.

Understand that depreciation is not an option. It's required by law. 

That said, depreciation recapture on property is 25%?

That's another clear indicator that either you don't understand what depreciation is and how it works, or (and the more likely) you misinterpreted whatever IRS publication you may have read, about depreciation.

You are required by federal law to depreciate any property used in a business. Passive business assets, such as residential rental real estate, are depreciated over 27.5 years. Non-passive business assets such as the building that is your primary place of business, is depreciated over 39 years. So any structure used for your SCH C business would be depreciated over 39 years. (There are exceptions, but they don't appear to apply here and I'm not going to add to the confusion by covering it.)

In the future when you sell or otherwise dispose of the property, you have to recapture all prior depreciation taken and pay taxes on it, in the year of disposition. You will be taxed on that recaptured depreciation anywhere from 0% up to a maximum of 25% in that year of disposition. Additionally, the recaptured depreciation will increase your AGI in that tax year, potentially bumping you into the next higher tax bracket. But if the tax bracket you're in is higher than the 24% bracket, that recaptured depreciation is still taxed at a maximum of 25%.

Overall, you need professional tax help. Especially if you state taxes personal income. Mistakes could easily become a double whammy for you with the IRS, as well as the state.

[M-MTax]

Passive business assets, such as residential rental real estate, are depreciated over 27.5 years. Non-passive business assets such as the building that is your primary place of business, is depreciated over 39 years. 

I don't get this at all. Whether an asset is non-passive or passive has nothing to do with its recovery period. 

Residential rental property has a recovery period of 27.5 years and nonresidential real property has a recovery period of 39 years. I can't see where it's any more complicated than that.

[klw085]

Yes, consider me further educated.  Thank you.

No, I have not done anything yet.  I am simply trying to understand any tax advantages by asking a couple of questions in an online anonymous forum for self tax preparers since the topic is one that is not that well covered using the various Google searches that I have performed to date.

I am familiar with plenty of professionals who purchase a condo to use solely for a home office.  Perhaps they already own a condo in the building and they need more room for an office and so they purchase another condo solely to work in.  They don't see customers.  It's not a storefront.  It's a remote work situation that deals with computer programming and administrative work.  I already have a business license from my state and town with my current home as the address because I devote a portion of my home as a home office and I was told that I needed to pay for a state and town license for my home office when I went to pay my state excise tax for my sole proprietorship.  This was not difficult to obtain.

I understand.  Purchase the home / condo.  Don't use it for anything but work.  It would be substantially smaller than my current home.  Begin depreciating it using commercial property depreciation.  No 179, no bonus depreciation.  Deduct it and various other expenses and interest and taxes for the property on your schedule C out of your 1099 income.  Should I ever decide to sell it would then need to pay any depreciation recapture and capital gains.  Be prepared for it to be challenged.  But, I work remotely and simply require some quiet space and a computer to do my work and to make phone and zoom calls.  I've outgrown my current home office.  There's little reason for me to purchase a commercial office space in order to do my programming job.

I get the gist.  I can run the numbers myself to get a very rough estimate about what if any financial benefits there may be.  Should it remain favorable and I consider this option more seriously I will likely seek professional help at that point.

In the past I have used a professional to do my taxes.  All he did was just my taxes.  There was little in the way of actual tax advice like start a defined benefit plan, the various pieces of equipment I could deduct, or say bonus depreciation on a heavy work vehicle to visit job sites.  It was just here's your tax return.  There was no planning.  I find that actually understanding some of the rules helps me better understand what questions and options to consider.  As my tax situation becomes more complicated perhaps I will seek further professional assistance in the future.

This is a forum for self-preparation of tax returns.  People will ask questions.

[Carl]

Since you're talking about something short term (A year, give or take I guess) why not just rent office space? Rent paid for office space would probable be the same as or cheaper than a mortgage payment. The rent paid would be a fully deductible business expense to, along with all the utility costs. Also, you don't have to deal with depreciation at all on that rented space. You'd only depreciate any business assets you put in that space, such as furniture. I would guess that all you'd be putting in a rented space would be the same stuff you have in your home office right now, that you may or may not already be depreciating. So nothing would change when you relocated those assets to a rented space.

Now I don't know where you're physically located, but in my locale in NE Florida one can rent a 24 X 12 foot space in a strip mall for around $1400/mo plus utilities.  It's also possible that there may be another business not related to your line of work that is renting space for their own business, and they may be willing to sub-let an unused room to you. I've seen this in a few doctor's and dentist's offices where they're not using one or more of the operatory/patient rooms and they rent out that one room to a programmer who only needs a small space anyway, for a table, one or two computers, telephone and other small tidbits. Generally, they will go for significantly less than renting a space in a strip mall for example.

[klw085]

I would be looking at using the property for at least five years. Maybe closer to ten. Then I would likely try and convert to personal use and hang on to it. Or just sell. 

[Carl]

Here's another idea, based on a few assumptions.

- I'm assuming you just need a workspace away from all the household noise where you can work without being disturbed or distracted, which is probably the issue you have now working in your house.

- I'm assuming you rarely (if ever) meet with clients face-to-face at home, and that would not change upon moving your operations elsewhere.

So by one of those pre-built wooden sheds like the ones pictured at https://www.lowes.com/pl/Wood-storage-sheds-Sheds-Sheds-outdoor-storage-Outdoors/4294612522?int_cmp=... and put it in the back yard or where-ever on your property. At less than $5K, the purchase "might" qualify as a safe-harbor de-minimus business deduction,meaning there's no need to depreciate it - just claim it as a full blown business expense; but only if current tax law allows that of course. ( @M-MTax would know more about this, as I know one factor might be if your property tax appraiser would consider it a permanent structure on the property, thus increasing your property taxes.) 

Have an electrician (unless you can do the work yourself) wire it up for you. I would think an extra circuit breaker or two in your existing electrical breaker box would do the trick, if your current electrical service can handle the addition of a 7000BTU window A/C unit in that barn. (I'm sure it can.) An overhead light or two and a few electrical plug outlets, for the computer equipment, and you're all set.

If you don't use a cell phone for your business yet, then get one. I myself have an el-cheapo Consumer Cellular phone I paid a whopping $37 for, and it's less than $30 a month for unlimited everything. The cost of the phone plus my monthly phone bill is 100% deductible as a business expense, since that's all I use it for.

Have the electrician install a porch light on the outside of the unit, that comes on whenever you turn on the inside light. That's the notice to the kids that if that light it on, you're working and they are forbidden under threat of being put up for adoption, to go anywhere near that shed, or even in the yard where the shed is located if that works for you. 🙂

So for less than $10K, you'd have the quiet and privacy needed, with no mortgage or rent payments.

[klw085]

Thanks for the response.  This is definitely an interesting idea.

That said, I would be interested in as large of a tax deduction as reasonably possible.  I actually have a fair amount of income from my business that I would like to "shelter".

In the end, I will approach a tax professional, as many here suggest, to see how feasible this option would be.  Thank you all for your information as this will help improve my subsequent conversation with them.

[Carl]

I would be interested in as large of a tax deduction as reasonably possible. I actually have a fair amount of income from my business that I would like to "shelter".

Just don't limit your line of thought on sheltering income to "the business". There are other ways to shelter income outside of the business. A tax pro and/or financial advisor would probably be most beneficial for expanding your train of thought on that front.  Probably beyond what you and I could even think of.

As an aside, I to am self-employed and have been since 2005. I've had what I call "armchair advisors" tell me that if I spend $10,000 on office furniture, then I"ll save about $2000 in taxes. For my needs, that's the dumbest thing I've heard anyone say. Why on earth would I want to spend $10K that I don't need to spend, just to save $2K in taxes? I'd much rather pay that $2K in taxes and put the remaining $8K in my wallet where it will never be taxed again, and I can do with it as I please.

Unless tax laws change, once you've paid your income tax on that income, it can never be taxed again. So I have no problem with paying my share of taxes on money that I get to keep. I do have a problem with paying taxes on money I don't get to keep - such as the principle part of a mortgage payment. That money is basically never mine - yet I have to pay taxes on it.

[M-MTax]

I do have a problem with paying taxes on money I don't get to keep - such as the principle part of a mortgage payment. That money is basically never mine - yet I have to pay taxes on it.

You have to pay taxes on the principal part of a mortgage? That's news to me and surely can't be right. You can deduct mortgage interest within limits and have to report income from mortgage interest if you lend someone money to buy real estate or whatever but you don't pay tax on the balance of the loans either way. 

[Carl]

You have to pay taxes on the principal part of a mortgage?

Of course! Everyone pays taxes on the principle part - but not the interest part. Don't see why that's news to anybody. To the best of my knowledge, the principle part of a mortgage payment has never been deductible. If it was, then that principle would be included on the 1098.