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Nicholas J. Fiore, J.D.

The reports of cases, rulings, etc., herein, except for the Reflections, are edited versions of the relevant court opinion, published ruling, etc.

Estates, Tr

IRS Provides Guidance on Employee Rental of Home to Employer

The employer is an S corporation of which T is the sole shareholder and sole employee. T rents a portion of his home to his employer. During the period of the rental, T used a rented portion in performing services as an employee. He also used the dwelling unit as a principal residence. T was concerned because he could not find a place on the applicable forms to claim certain business expenses and depreciation attributable to the rental income.

Issue

How should an individual who rents a portion of his dwelling unit to his employer and who uses the dwelling unit in performing services as an employee of that employer treat the expenses attributable to the rental of the dwelling unit?

Analysis

In general, Sec. 280A applies to individuals who use their homes both for personal purposes and for the production of trade or business income. The section is designed both to ensure that the business use of the home does not result in an inappropriate conversion of nondeductible personal, living and family expenses into deductible expenses, and to permit the deduction of legitimate business expenses incurred in using the home to earn income.

Sec. 280A(a) and (b), taken together, permit an individual who pays home mortgage interest expense and state and local real property taxes to deduct those payments—if he meets the rules found in Secs. 163(h) and 164(a)(1)—regardless of whether that individual uses his residence solely for personal purposes or for both personal and business purposes.

Deductions for the business use of a home are potentially available only if the use falls into one of the four categories listed in Sec. 280A(c)(1)(4). Those categories are specified home office uses (Sec. 280A(c)(1)(A),(B) and (C)); storage of inventory or product samples in the home (Sec. 280A(c)(2)); rental of the property (Sec. 280A(c)(3)); and use of the home in providing day-care services (Sec. 280A(c)(4)). In general, the business expenses associated with those uses are deductible only if the individual's business use of the home is regular (rather than occasional or incidental), and only to the extent the income earned from the business use of the home equals or exceeds the business expenses. Sec. 280A further requires both that expenses be reasonably allocated between business and personal use and that expenses be taken in a specified order. In addition to these general rules, particular rules apply to some of the business uses listed above. Pub. 587, Business Use of Your Home (2000), contains a detailed description of the various Sec. 280A rules.

T's questions involve a corporate employee whose receipt of business income and whose incurring of business expenses relate to three of the Sec. 280A(c) business uses listed above—the home-office uses and the rental use. For discussion, assume there are two hypothetical employees (E-1 and E-2), both of whom use part of their homes (but not a separate structure detached from the dwelling unit) in performing services for their employers and both of whom are the sole shareholders of their S corporations. Also assume that E-1 receives a reasonable salary from her employer (includible in her gross income under Sec. 61(a)(1)) and seeks to claim a home-office deduction, and that E-2 receives a reasonable rent from his employer (includible in his gross income under Sec. 61(a)(4)) and seeks to deduct business expenses related to that rental.

To claim a home-office deduction, E-1 must satisfy both the general requirements of Sec. 280A and the particular requirements of Sec. 280A(c)(1)(A) or (B). Specifically, under Sec. 280A(c)(1), E-1 must show that she used her home office exclusively and regularly, either as (1) her principal place of business in her trade or business of being an employee or as (2) a place of business in which she meets or deals with patients, clients or customers in the normal course of her business. In addition, E-1 must show that her exclusive use of the home office is for her employer's convenience.

If E-1 can meet the general and specific rules of Sec. 280A, she should calculate her home-office expense deduction by using the worksheet contained in Pub. 587. Such expenses are generally claimed on various lines of Schedule A. Pub. 587 (2000), pp. 1617, contains an example of how taxpayers should calculate and report the expenses, and provide information about additional forms that a taxpayer may need in some circumstances to prepare and file.

Because E-2 is receiving rental rather than salary income from his employer, he is not allowed to deduct business expenses attributable to the rental income. This result comes about not because it is more difficult to satisfy the rental-use tests than the home-office-use tests (indeed, ordinarily the opposite is true), but because of the particular disallowance rule of Sec. 280A(c)(6).

Sec. 280(A)(c)(6) provides that:

Treatment of rental to employer. Paragraphs [c](1) and [c](3) shall not apply to any item which is attributable to the rental of the dwelling unit (or any portion thereof) by the taxpayer to his employer during any period in which the taxpayer uses the dwelling unit (or portion) in performing services as an employee of the employer.

E-2 falls squarely within Sec. 280A(c)(6) because he is both renting to his employer and using the rented portion of his dwelling unit to perform services as an employee. Accordingly, Sec. 280A(c)(6) will bar E-2 from deducting otherwise allowable Sec. 162 trade or business expenses, Sec. 165(c)(1) business casualty losses and Sec. 167 depreciation. That statutory bar, in turn, explains why there is no place on the forms to deduct those expenses.

Congress added Sec. 280A(c)(6) expressly to overturn the Tax Court's decision in Feldman, 84 TC 1 (1985), aff'd, 791 F2d 781 (9th Cir. 1986). In enacting Sec. 280(A)(c)(6), Congress observed that the Tax Court's interpretation of Sec. 280A in Feldman could lead to the circumvention of statutory restrictions on the deduction of home-office expenses. In particular, Congress was concerned that (1) employers and employees could arrange sham transactions (by which a portion of salary was paid in the form of rent) and (2) the employer-employee transactions would not be negotiated at arm's length, but would provide added tax deductions for the employee at no additional cost to the employer. Accordingly, Congress provided that no home-office deductions were allowable (other than expenses such as home mortgage interest and real estate taxes that are deductible absent business use) if an employee rents a portion of his home to his employer.

It should be noted, however, that although Sec. 280A applies to S corporations as well as to individuals, the only taxpayer to whom Sec. 280A(c)(6) refers is the employee. Thus, for example, Sec. 280(c)(6) does not affect an S corporation's deduction under Sec. 162 for rent.

Conclusion

T may deduct home mortgage interest, real property taxes and personal casualty losses to the extent permitted by Secs. 163, 164 and 165(c)(3) and (h). However, the individual may not deduct otherwise allowable trade or business expenses under Sec. 162, business casualty losses under Sec. 165(c)(1) or depreciation under Sec. 167, to the extent those expenses and losses are attributable to T's use of the dwelling unit in performing services for the employer.

IRS Letter Ruling (TAM) 200121070 (3/19/01)