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Individual Tax

Guidance explains interaction of SALT deduction and home expense deduction

Thomson Reuters Tax & Accounting  

Thomson Reuters Tax & Accounting  

Program Manager Technical Advice 2019-001

Program Manager Technical Advice 2019-001

In a Program Manager Technical Advice (PMTA), IRS has explained the interplay between the $10,000 limitation on state and local taxes (SALT) deduction provided in Code Sec. 164(b)(6), as added by the Tax Cuts and Jobs Act (TCJA; P.L. 115-97, 12/22/2017), and the amounts that are excepted from the general disallowance of expenses in connection with business use of a home under Code Sec. 280A(b).

Background on SALT deduction. Code Sec. 164 generally provides an itemized deduction for certain taxes paid or accrued during the tax year. Code Sec. 164(a) provides a deduction for (1) state and local, and foreign, real property taxes; (2) state and local personal property taxes; (3) state and local, and foreign, income, war profits and excess profits taxes; and (4) the generation-skipping transfer tax imposed on income distributions. Code Sec. 164(a) also provides a deduction for state and local, and foreign, taxes not previously described that were paid or accrued within the tax year in carrying on any trade or business or an activity described in Code Sec. 212(relating to expenses for production of income).

Code Sec. 164(b)(5) allows a taxpayer to elect to deduct state and local general sales taxes in lieu of state and local income taxes.

Code Sec. 164(b)(6), as added by TCJA, limits an individual’s deduction for the aggregate amount of state and local taxes paid during the calendar year to $10,000 ($5,000 in the case of a married individual filing a separate return). The dollar limitations apply to tax years beginning after Dec. 31, 2017, and before Jan. 1, 2026, but they do not apply to foreign taxes described in Code Sec. 164(a)(3) or to any taxes described in Code Sec. 164(a)(1)and Code Sec. 164(a)(2) that are paid or accrued in carrying on a trade or business or an activity described in Code Sec. 212.

Background on home expense deduction. Code Sec. 280A(a) disallows to individuals and S corporations any deduction for expenses related to a dwelling unit used as a taxpayer’s residence during the tax year unless another provision of Code Sec. 280A specifically allows the deduction. Code Sec. 280A(b) excepts from this disallowance 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 Code Sections).

Code Sec. 280A(c)(1) through Code Sec. 280A(c)(4) excepts from the Code Sec. 280A(a) disallowance certain expenses related to certain business or rental uses of a dwelling unit–use as a home office; for storage of inventory or product samples; rental of the dwelling unit; and use as a day care business.

However, deductions under Code Sec. 280A(c) are limited to the activity’s gross income reduced by all other deductible expenses that are allowable regardless of qualified use (e.g., mortgage interest, real estate taxes, and certain casualty losses) and by the business deductions that aren’t allocable to the use of the home itself (e.g., expenses of advertising, wages, and supplies). Expenses disallowed solely because they exceed business income can be carried forward, subject to the gross income limitation in the later year. (Code Sec. 280A(c)(5))

Guidance. In Program Manager Technical Advice 2019-001, IRS states that if a taxpayer’s total individual state and local taxes meet or exceed the $10,000 limitation of Code Sec. 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 Code Sec. 280A(b). If a taxpayer’s total individual state and local taxes do not meet or exceed the $10,000 limitation of Code Sec. 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 Code Sec. 280A(b) the business portion of the state and local taxes up to the difference between the limitation under Code Sec. 164(b)(6) and the amount of individual state and local taxes that the taxpayer actually deducted under Code Sec. 164.

Because the limitation under Code Sec. 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 Code Sec. 164(b)(6), then the taxpayer does not have any additional taxes that would be deductible under Code Sec. 164(b)(6). In that case, the entire business portion of the state and local taxes would be considered a Code Sec. 280A(c) expense subject to the gross income limitation under Code Sec. 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 Code Sec. 164(b)(6), and the entire business portion of the state and local taxes would be considered a Code Sec. 280A(c) expense subject to the gross income limitation under Code Sec. 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 Code Sec. 164(b)(6), if that taxpayer had state and local taxes attributable to the income-producing activity, the taxpayer could deduct as a Code Sec. 280A(b) expense the amount of state and local taxes attributable to the business, up to the difference between the $10,000 limitation under Code Sec. 164(b)(6) and the taxpayer’s total individual taxes under Code Sec. 164. The rest of the state and local taxes attributable to the business would be expenses under Code Sec. 280A(c) and would be subject to the gross income limitation under Code Sec. 280A(c)(5).

The PMTA provided the following examples:

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 Code Sec. 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 Code Sec. 164(b)(6), Taxpayer’s $4,000 of real estate taxes attributable to the rental are expenses under Code Sec. 280A(c) and are subject to the gross income limitation under Code Sec. 280A(c)(5). None of Taxpayer’s real estate taxes attributable to the rental use of the Taxpayer’s home are expenses under Code Sec. 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 Code Sec. 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 Code Sec. 164(b)(6). As such, Taxpayer can include as a Code Sec. 280A(b) expense the $1,000 (the difference between the $10,000 limitation under Code Sec. 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 Code Sec. 280A(c)(5). The rest of Taxpayer’s real estate taxes attributable to the rental use of the home ($7,000) are Code Sec. 280A(c) expenses and are subject to the gross income limitation under Code Sec. 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 Code Sec. 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 Code Sec. 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 Code Sec. 280A(c) expenses and are subject to the gross income limitation of Code Sec. 280A(c)(5).

Other itemized deductions. IRS notes that the above methodology also applies when applying the rules in Code Sec. 280A to other itemized deductions available to individuals (i.e., mortgage interest and casualty losses).

References: For the deduction for state and local taxes, see FTC 2d/FIN ¶K-4500United States Tax Reporter ¶1644.03. For rental of vacation homes, see FTC 2d/FIN ¶M-6000 et seq.; United States Tax Reporter ¶280A4.

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