Home Improvements that are Direct and Indirect Home Office Expenses

[weaslebub]

This issue deals with our tax returns for the years 2020-2022.  A series of health-related issues caused me to get behind on our filings.  It's been a difficult road back, but I'm slowly getting things caught up and can really use some help.

My wife owns a business and has a home office with a waiting room for her students and parents. We had some large improvement projects completed on the entire house between 2020-2022 that benefit or overlap with her office and waiting room areas.

First, we replaced all the windows in the house, followed by the entire 12'x11' front door assembly.  Everything was completed in phases due to the high cost.

• The first phase of replacing our windows began in July 2020.  We signed the first contract to replace half the windows in our house and paid 50% of the cost with our order.  This payment was equal to 2% of our home’s 2020 tax appraised value.  It took until March 2021 for the windows to be delivered and installed, and we paid the remaining 50% balance on the order at that time, which was 2% of our home’s 2021 tax appraised value.  So, the payments for this phase occurred in tax years 2020-2021.

• The second phase included all the remaining windows and began in April 2021.  Along with the windows, we also ordered a new front door and window assembly to replace our old, termite-eaten door assembly that had become unstable and was no longer safe to use.  We again paid 50% of the total contract up front, or 2% of our home’s 2021 tax valuation.  The window order arrived in October 2021, however, nearly half of them were damaged in-transit and had to be remade.  No work was done until May 2022 when the windows and the new front door assembly were delivered.  We paid the remaining 50% balance that was due on the order after installation was complete.  However, due to a large increase in our tax appraisal that year, the final payment was only equal to 1% of our 2022 tax valuation.  So, like the first window contract, the second contract was paid for in two tax years - half in 2021 and half in 2022 totaling 3% of our home’s appraised value. Altogether, the total for the new windows and door project was 7% of our home’s tax appraised value and payments occurred in tax years 2020-2022.

During these same years, we also replaced all the flooring and baseboards in the house.  It also had to be completed in phases to accommodate repairs and preparations needing to be done as the project progressed.  The total cost of all phases was equal to 6% of our home’s tax appraised value and broke down as follows:

• The first phase of new flooring was completed and paid for in October 2020.  The total was 1% of our home’s 2020 tax valuation.

• The second phase was for new hardwood flooring throughout our entire downstairs, including the home office and waiting room areas.  It was completed and paid for in July 2021.  The total was 4% of our 2021 tax valuation.

• The final phase was for new flooring on the staircases and new baseboards throughout the entire house.  It was completed and paid for in March 2022, and the total was 1% of our home’s 2022 tax valuation.  However, the baseboards still needed to be caulked and painted, but that work wasn’t addressed until late 2022 when we hired a painter to complete this and other interior painting projects.  The baseboard painting added another 1% of our home’s 2022 tax valuation to the cost of our flooring project.  The cost of the other painting projects was 2% of our 2022 tax value, but we removed that part because it was for painting our stairway and loft, which are both open to the waiting area and visible to customers, but technically are not part of the home office. (Am I thinking about this correctly, or should these other painting projects be included somewhere?)

Below are the questions that are holding us up right now.  Some may seem pretty basic and even redundant, but that’s because we aren’t sure if we’re stating our concerns correctly or asking all the right questions.  Perhaps we're just over-thinking everything, I'm not really sure.  Having never made improvements of this size to our home before, I don’t have the experience or instinct to guide me through all the possible tax considerations, but it makes sense that we’d want to add the improvements to our cost basis and identify all the possible tax benefits from them (tax credits and deductions).  I’m just not sure where all to look for possible tax benefits, or how I’d know I’ve covered everything and can move on.  So, we just need help to ensure that we’re doing everything on our tax return that we’re supposed to do, and that we’re taking advantage of everything we can and should be doing under the circumstances.

(Sorry about the spacing.  I had trouble adding blank lines between questions without the editor automatically renumbering them.)

Questions: (our 2020-2022 returns currently include Forms 1040, 8829, 5695, and Schedule C)

1. When large improvements are made to your home, what parts of a tax return could potentially be impacted and need to be looked at?  What about when there’s a home office?  Are there any critical entries or forms that you can say without question need to be completed or at least reviewed? 

2. For general improvements made to the whole house: 

   1. What needs to be done when improvements (or portions of improvements) directly impact the home office, like in the case with our 2020-2022 improvement projects? 
   2. What about if projects only indirectly affect the home office, like when we had new baseboards caulked and painted along with the stairway and loft areas that customers can see?  Or other improvements like a whole-house water purifier, or new AC ductwork? 
   3. How would exterior projects be treated, like painting the exterior, installing new gutters and a railing on the front stairs, installing exterior lighting, tree trimming, replacing the fence, or in the case where we had to replace our front door assembly for safety reasons? 
   4. My wife’s business has people coming and going throughout the day and staying for 1 to 3 hours.  Understandably, she wants everything to be safe and as professional looking as possible.  This means keeping up the landscaping, cleaning. and maintenance on everything her customers will see or use while they are here (including the bathroom and kitchen area by the waiting room).  We can’t increase the business use percent because of the exclusivity test, but having these customers in the house for periods of time throughout the day raises the question about whether more of our home’s maintenance and improvement expenses might be deductible as home office expenses, along with some expenses we wouldn’t otherwise have, like cleaning, landscape services, and the things listed above in line 3.  Things like tree trimming are mentioned because branches and limbs become a falling hazard and put customers at risk when walking in and out if they aren't kept up.  Lighting is a big safety and liability issue during the winter months when customers are there after dark.  So, does having customers coming and going during the day and staying for extended periods of time affect which maintenance and improvement expenses might be eligible to include with the home office?  The longer they stay, the greater the need for things like restroom and kitchen/refrigerator access.

3. We replaced ten windows that are in the home office and waiting room area, and it seems like deducting these as an office expense could provide a bigger tax benefit than just deducting the business use percent of the entire window project.

   1. Would the office portion of these projects be Section 179 expensed, depreciated, or handled another way?  Where in TTax does this need to be entered, and would it be considered a direct or indirect expense? Would the flooring and baseboard project be handled the same as the windows?
   2. The rules seem somewhat loose when it comes to using Section 179 to fully expense or depreciate certain business costs.  Is the $2500 limit on Section 179 expenses an official amount, or is it just a suggested amount to consider depreciating at?  I’m asking because TurboTax doesn’t prevent me from entering business expenses greater than $2500 in the Misc Expenses section.  These improvements could have a big impact on our taxes and cost basis, so it’s not something we can take lightly or risk making any mistakes with.  I just need to be certain thar we handle everything correctly and understand it enough to explain what we did if we ever got audited.
   3. Is there a rule of thumb for deciding when to expense versus depreciate?  Can any amount be expensed?  Can any amount be depreciated?  If I wanted to expense a $3000 window in my home office, would this go in the Misc Expenses section, or would it be added as an asset and fully expensed there?  Would a $1000 window be handled any different?  Are there circumstances or types of improvements that wouldn’t be added as an asset? 

4. How should we handle improvements that are completed and paid for across multiple tax years?  Do we treat each tax year separately whether the work is finished or not, or do we wait until everything is done and paid for?  Or should this be handled another way?

5. Is there a form we need to submit or entries to make somewhere in TurboTax to document the improvements we make (for depreciating and cost basis tracking)?  If so, which specific forms or line entries need to be completed?  If not, how would the IRS know if there have been changes to our cost basis?  What about changes to our cost basis from improvements that didn’t affect our home office, like remodeling a shower?

6. All the windows we installed qualify for the Energy Credit, and ten of these were in the home office.  If a home improvement qualifies for an Energy Credit but it's also a home office expense, do we need to choose one or the other, or are we entitled to both the credit and the deduction?  Would we reduce total window cost that gets entered for the credit by the amount that was expensed in the home office?  So, if the window cost is $1000 and the office size is 10% of our house, would we use Section 179 to expense $100 in the home office assets, and then enter $900 as the total window cost in the Energy Credit section?  Or would we still enter the full $1000 for the credit?

7. When should labor or installation costs be deducted from the cost of an improvement? For Energy Credit calculation?  For cost basis calculation?  For asset entry and expensing?  

   1. What should we do if there are no specific charges for labor or installation detailed in the bid estimates or receipts?  The window contractors we received bids from charged a flat amount per window that included manufacturing, shipping, removal, installation, and a warranty.  If you bought a window from these companies, you would pay the same amount per window whether you wanted the complete full-service or just a box of unassembled window frame parts and glass shipped to your doorstep.  The only separate charges shown were for disposal fees.  No labor or installation charges are listed anywhere.  Maybe it’s not as important for cost basis or depreciating purposes, but in the Home Energy Credits section, the rules for window upgrades say not to include the labor and installation cost.  So, we’re not sure what to do.

Many, many thanks for your help and clarification!