In a Program Manager Technical Advice that must be parsed carefully (PMTA 2019-001), the IRS discusses the interplay between the office in home deduction under IRC §280A and the $10,000 cap on state and local taxes under IRC §164(b) added by the Tax Cuts and Jobs Act (TCJA).  If the reader is not careful, he/she may jump to a very taxpayer unfriendly conclusion.

The PMTA comes to the following conclusion that may alarm readers at first:

If a taxpayer’s total individual state and local taxes meet or exceed the $10,000 limitation of §164(b)(6), or if the taxpayer chooses to take the standard deduction instead of itemizing deductions, none of the taxpayer’s state and local taxes relating to taxpayer’s business use of the home are included as expenses under §280A(b). If a taxpayer’s total individual state and local taxes do not meet or exceed the $10,000 limitation of §164(b)(6), and the taxpayer does not opt to take the standard deduction in lieu of itemized deductions, then the taxpayer can include as expenses under §280A(b) the business portion of the state and local taxes up to the difference between the limitation under §164(b)(6) and the amount of individual state and local taxes that the taxpayer actually deducted under §164.

The first sentence may suggest to those that don’t read carefully that a taxpayer could never get a deduction for real estate taxes allocable to the home office if he/she is already deducting over $10,000 in state and local taxes.  But the conclusion paragraph has a footnote reference at the end of that first sentence.  The footnote reads:

Expenses relating to the taxpayer’s exclusive use of a portion of the taxpayer’s home for business purposes could still be deductible under a different exception to the general disallowance in §280A(a), for example, under §280A(c), but such deductions would be subject to the specific limitations in that exception.

IRC §280A(a) generally prevents taxpayers from deducting as business expenses any deduction which is incurred with respect to property used by the taxpayer as a residence during the year.  However, the rest of IRC §280A contains various exceptions to this prohibition, as well as conditions that must be met to claim an office in home deduction.

The first exception, found at IRC §280A(b), provides the following special rule for items that would otherwise be deductible on the taxpayer’s return:

(b) Exception for interest, taxes, casualty losses, etc.

Subsection (a) shall not apply to any deduction allowable to the taxpayer without regard to its connection with his trade or business (or with his income-producing activity).

The PMTA explains the purpose behind this initial exception:

Section 280A(b) excepts from §280A(a) deductions allowable to the taxpayer without regard to the deduction’s connection with the taxpayer’s trade, business, or income-producing activity (i.e., mortgage interest, certain taxes, certain casualty losses that are allowable to individuals under other provisions of the Internal Revenue Code). Section 280A(b) is essentially a parity provision that prevents §280A(a) from limiting home expenses that would otherwise be allowable to individuals who are not using part of their home for trade, business, or other income-producing activity.

Deductions that cannot fit within IRC §280A(b)’s exception may still be allowed pursuant to the rules of IRC §280A(c).  But §280A(c) imposes limits on the deductions that work to prevent such expenses (other than those the taxpayer would have qualified to deduct even without a home office) to no more than the income from the trade or business or rental. 

The PMTA gives the following explanation of how the limit under IRC §280A(c) is computed:

The PMTA explains how the $10,000 cap interacts with these provisions:

Because the limitation under §164(b)(6) is calculated by combining the taxpayer’s state and local taxes, a taxpayer using a portion of the taxpayer’s residence for an income-producing purpose must first calculate the percentage of the business use of the home and then apply that percentage to the total amount of state and local taxes paid in connection with the ownership of that home to determine the portion of the state and local taxes attributable to the business use of the home and the portion attributable to the individual use of the home. Once that determination is made, the taxpayer combines the individual use portion with the taxpayer’s other individual state and local taxes paid (income taxes or sales taxes, personal property taxes, war profits, excess profits taxes, and other real property taxes) to determine the taxpayer’s total individual state and local taxes. If that amount meets or exceeds the $10,000 limitation under §164(b)(6), then the taxpayer does not have any additional taxes that would be deductible under §164(b)(6). In that case, the entire business portion of the state and local taxes would be considered a §280A(c) expense subject to the gross income limitation under §280A(c)(5). Similarly, if a taxpayer opts to take the standard deduction in lieu of itemizing deductions, then the taxpayer is not entitled to any deduction under §164(b)(6), and the entire business portion of the state and local taxes would be considered a §280A(c) expense subject to the gross income limitation under §280A(c)(5).

In the case of a taxpayer whose individual state and local taxes do not meet or exceed the $10,000 limitation under §164(b)(6), if that taxpayer had state and local taxes attributable to the income-producing activity, the taxpayer could deduct as a §280A(b) expense the amount of state and local taxes attributable to the business, up to the difference between the $10,000 limitation under §164(b)(6) and the taxpayer’s total individual taxes under §164. The rest of the state and local taxes attributable to the business would be expenses under §280A(c) and would be subject to the gross income limitation under §280A(c)(5).

Taxpayers with state and local taxes in excess of the $10,000 limit will be forced to treat the real estate taxes allocable to home office as a §280A(c) limited expense—the amount can be deducted, along with other §280A(c) expenses, to the extent there is sufficient income from the trade, business or rental.  If not, the unused portion of the deduction is carried forward to be potentially used in future years when the taxpayer has income from the trade, business or rental.

The PMTA contains the following examples of applying its holdings:

Example 1: Taxpayer has a home that he rents for 1/3 of the year. Taxpayer’s real estate taxes on the home are $12,000. Taxpayer also pays $5,000 in state and local income taxes. The real estate taxes are allocated $8,000 to the individual use of the home and $4,000 to the rental use of the home. Taxpayer’s total individual state and local taxes paid equal $13,000 (i.e., $8,000 individual real estate taxes plus $5,000 state and local income taxes). Under §164(b)(6), Taxpayer’s individual itemized deduction for state and local taxes is limited to $10,000. Because Taxpayer’s actual individual state and local taxes exceeds to the $10,000 limit under §164(b)(6), Taxpayer’s $4,000 of real estate taxes attributable to the rental are expenses under §280A(c) and are subject to the gross income limitation under §280A(c)(5). None of Taxpayer’s real estate taxes attributable to the rental use of the Taxpayer’s home are expenses under §280A(b).

Example 2: The facts are the same as Example 1, except that Taxpayer rents the home for 2/3 of the year. In this example, the real estate taxes are allocated $4,000 to the individual use of the home and $8,000 to the rental use of the home. Taxpayer also paid $12,000 in mortgage interest on the home but had no other itemized deductions. Therefore, Taxpayer’s total individual state and local taxes equal $9,000 ($4,000 individual real estate taxes plus $5,000 state and local income taxes) and Taxpayer’s total individual itemized deductions equal $13,000 ($9,000 in state and local taxes plus $4,000 in mortgage interest (1/3 of the total mortgage interest paid)). Taxpayer’s itemized deductions exceed the standard deduction amount of $12,000, so Taxpayer chooses to itemize his deductions. Taxpayer’s total individual state and local taxes do not meet or exceed the $10,000 limitation in §164(b)(6). If Taxpayer had not rented his home, Taxpayer would have been able to deduct an additional $1,000 of the real estate taxes, which are currently attributable to the business use of the home, as individual state and local taxes under §164(b)(6). As such, Taxpayer can include as a §280A(b) expense the $1,000 (the difference between the $10,000 limitation under §164(b)(6) and $9,000 (Taxpayer’s total individual state and local taxes)), and such amount will not be subject to the gross income limitation of §280A(c)(5). The rest of Taxpayer’s real estate taxes attributable to the rental use of the home ($7,000) are §280A(c) expenses and are subject to the gross income limitation under §280A(c)(5).

Example 3: The facts are the same as Example 2, except that Taxpayer did not pay any mortgage interest on the home. As such, Taxpayer had a total of $9,000 in individual itemized deductions and opted to take the standard deduction of $12,000 under §63(c) instead of itemizing his deductions. Because Taxpayer opted to take the standard deduction in lieu of itemized deductions, there is no amount of state and local taxes that would have otherwise been allowable to Taxpayer under § 164 but for the rental use of the home. As such, all of the real estate taxes attributable to the rental use of the home are §280A(c) expenses and are subject to the gross income limitation of §280A(c)(5).

The PMTA ends by noting that similar logic would apply to other deductions subject to various limitations or disallowances, including home mortgage interest and casualty losses.  Thus interest on the mortgage balance in excess of the acquisition debt limitations would become §280A(c) limited expenses when claiming a home office deduction.