Wednesday, November 14, 2007

ASK THE TAX PRO – ALLOWED OR ALLOWABLE

Q. I read your article entitled "Home Office Expenses of a One-Man Corporation" and found it very helpful. One point you made in the article is that you cannot reimburse for depreciation on the home office. Then later, you said that when you sell your home you do not have to recapture the depreciation unless you were reimbursed for it. Keep in mind, I am summarizing and leaving out some of your discussion.
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I have understood that you have to recapture the greater of the allowed or the allowable on depreciation. That being the case, if my understanding is correct, would you not have to recapture the depreciation that you could have somehow taken using the office in home? In other words, isn't depreciation required to be computed even though you did not claim the deduction anywhere on the return?
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I am probably getting twisted up in the rules a little. I appreciate your input on this.
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Best regards,
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SS, CPA
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A. You must "recapture" depreciation that is "allowed or allowable”.
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Depreciation that you have actually deducted on your tax return (and was not disallowed by the IRS) has been “allowed”. Depreciation that can be deducted on a tax return is “allowable”.
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In the case of a home office for a one-man corporation, where you cannot reimburse yourself for depreciation, depreciation is neither “allowed” nor “allowable”. If the Tax Code, or some official interpretation thereof, prevents you from taking a deduction for depreciation, a depreciation deduction is not “allowable”.
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The “allowed or allowable” rule comes into play when you are able to claim a deduction for depreciation on your tax return, but for some reason you elect not to do so. For example, if you had a rental property for which you reported income and deductions on Schedule E, but over the years never deducted depreciation on the property (God only knows why). When you sell the rental property you must add back, or “recapture”, the depreciation that you would have been able to claim as a deduction on the building during the years that it was available for rent. This is depreciation that was “allowable” under the Tax Code.
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I hope I have clarified the issue for you. Let me know if you have any other questions.
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Fellow tax bloggers – am I correct here?
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TTFN

11 comments:

Anonymous said...

Ok, I am with you on this so far and appreciate your insight. My only added comment/question is if you think it is possible that the IRS could argue that depreciation was allowable as an unreimbursed employee expense and should have been taken on Schedule A to the extent the depreciation and other misc. expenses exceed 2% of AGI? I know you said that the S Corp. can't reimburse for this, but just because they can't reimburse for this doesn't mean that the S Corp shareholder-employee can't claim the deduction here. If the shareholder-employee was not reimbursed for any of the out-of-pocket expenses, couldn't she deduct the depreciation for home office on Schedule A misc. item. deduction? Let me know if I am missing something.

Robert D Flach said...

Anonymous-

You raise an interesting point. Is the depreciation deduction “allowable” as a business deduction, just not “allowed” for reimbursement under an accountable plan, and therefore subject to recapture under “allowed or allowable”?

The IRS says “If you were entitled to take depreciation deductions because you used your home for business, you cannot exclude the part of your gain equal to any depreciation allowed or allowable as a deduction for periods after May 6, 1997”. The entitled clearly refers to the “allowable” rule.

One of the resources used for the posting was the article “Options for an Incorporated Business” from the May 2003 NATP TaxPro Monthly, which said:

“Since the reimbursement is only for out-of-pocket expenses, no depreciation is allowed. This method will save the taxpayer from the task of having to recapture depreciation when the home is sold.”

I emailed the NATP to ask about their documentation for this statement and was told since the article was published so long ago I would have to submit my inquiry as a “research question” and pay the appropriate fee. It is not worth the $21.50 or so just to satisfy my curiosity, or to provide an answer to a free blog question.

Here is one additional thought on the subject. If the taxpayer can claim the unreimbursed depreciation for the home office on Form 2106 and carry it over to Schedule A, but the 2% of AGI exclusion does not “allow” the taxpayer to claim a tax deduction (i.e. the deduction "allowable" is limited to the excess of 2% of AGI), than wouldn’t the depreciation not be “allowable”?

I will continue to look further into this issue at my leisure and report any additional findings in a future posting. In the meantime I welcome the comments of other tax professionals on this issue.

TWTP

SS CPA said...

Thanks! You had an interesting point that I wasn't clear on. The depreciation deduction would not be "allowable" unless it exceeded the 2% of AGI making it deductible on Schedule A. That is an important point. Thanks for all your help on this. If I find something on this as well, I will add it to the blog. I may try to check that article you referenced.

SS CPA said...

I did some checking on the definition of "allowable". In the Regulations - Reg. Sec. 1.1016-3(b)(2) states "The amount properly allowable as deductions in computing taxable income under subtitle A of the Code or prior income tax laws (whether or not the amount properly allowable would have caused a reduction for any taxable year of the taxpayer's taxes)." In our discussion, I think this means that the depreciation, if allowable as a deduction on Form 2106, then the basis of the property would be reduced by this amount, even if deducting this would not cause the taxpayer to have miscellaneous itemized deductions that would exceed 2% of AGI, and therefore resulting in tax savings on the return. Does that make sense to you? Do you agree? Also, I think there are provisions for recovering all unclaimed depreciation for open and closed tax years. The procedures for doing so are discussed in Revenue Procedure 2002-9 and Form 3115. I haven't studied these though.

Robert D Flach said...

SS CPA-

I believe that when the Reg states “whether or not the amount properly allowable would have caused a reduction for any taxable year of the taxpayer’s taxes” it refers to a situation where the depreciation deduction would reduce taxable income to below “0” or increase a negative net taxable income.

For example, if the depreciation deduction is $2,000 and Line 41 of the 2006 Form 1040 (Adjusted Gross Income less Itemized Deductions or Standard Deduction) is $(3,000). Line 43 – Taxable Income – would then be “0”. In such a situation the allowable depreciation would not have caused a reduction of the taxpayer’s taxes.

The Reg does not state “caused a reduction for any taxable year of the taxpayer’s taxable income”. I stand by my opinion that a depreciation deduction that is wiped out by the 2% of AGI exclusion is not “allowable”.

HAPPY THANKSGIVING!

TWTP

SS CPA said...

You are probably right. What you are saying makes sense. A deduction is not allowable in computing taxable income unless it can be counted towards reducing taxable income and it can't be counted unless it rises above the 2% threshold. Thanks for your help! I really appreciate your time and attention on this!

Robert D Flach said...

SS CPA -

Glad to be of help. I enjoyed the discussion.

By the way, perhaps you would like to comment on my idea of doing away with the deduction for depreciation of real estate on the 1040 that I talked about in the posting “HERE IS SOMETHING TO THINK ABOUT”.

TWTP

AB said...

Hi Robert - found this post through Google and have spent some time looking around - thanks for the excellent info on so many tax related issues!

A question related to this allowed or allowable post.

If I have a rental property (overseas, though I understand that doesn't matter to Uncle Sam) and I never once benefit from the "allowable" depreciation in the years right up to the day I sell the property, do I have any leg to stand on in in terms of avoiding being penalized on the depreciation recapture when we sell the property?

I live overseas so for various reasons (foreign earned income exclusion being one of them), I don't owe taxes when all is said and done so the "allowable" depreciation on our rental property never benefits us....ie it never actually becomes "allowed".

Will Uncle Sam listen to reason on this at all? I've heard of some court cases where the fact that someone had never benefited from the depreciation allowed them to avoid the depreciation recapture, but this is just hearsay at the moment.

Any thoughts on this?

Keep up the good blogging!

-AB

Robert D Flach said...

AB-

There is no exception that I know of for “allowed or allowable”.

While I am not experienced in the foreign tax exclusion (I haven’t used it in 30 years – since my days at Deloitte Haskins + Sells), I am not aware of any special “dispensation”. In your case it is allowed, you just get no tax benefit from it.

Uncle Sam listen to reason? Are you kidding!

I am not aware of any particular court cases – if you find any let me know.

TWTP

LuckyMe said...

A little late but wouldn't this apply?

http://www.irs.gov/irb/2004-06_IRB/ar09.html#d0e1426

Application of the Allowed or Allowable Rule to Changes in Method of Accounting

Section 1016(a)(2) provides that the basis of property is adjusted in respect of any period since February 28, 1913, for exhaustion, wear and tear, obsolescence, amortization, and depletion, to the extent of the amount allowed as deductions in computing taxable income and resulting in a reduction for any taxable year of the taxpayer’s taxes, but not less than the amount allowable.

Concurrently with the issuance of these regulations, the IRS and Treasury Department will issue a revenue procedure that will allow a taxpayer to change the taxpayer’s method of determining depreciation for a depreciable or amortizable asset after its disposition if the taxpayer did not take into account any depreciation allowance, or did take into account some depreciation but less than the depreciation allowable, for the asset in computing taxable income in the year of disposition or in prior taxable years. Because the taxpayer is permitted to claim the allowable depreciation not taken into account for this asset, the taxpayer’s lifetime income is not permanently affected by the “allowed or allowable” rule under section 1016(a)(2). Accordingly, the regulations provide that section 1016(a)(2) does not permanently affect a taxpayer’s lifetime income for purposes of determining whether a change in depreciation is a change in method of accounting under section 446(e) and th e regulations under section 446(e).

The revenue procedure also will revise the depreciation changes included in Rev. Proc. 2002-9, 2002-1 C.B. 327, the automatic change in method of accounting revenue procedure, to conform with these regulations and will waive the application of Rev. Rul. 90-38, 1990-1 C.B. 57, for changes in depreciation made under Rev. Proc. 97-27, 1997-1 C.B. 680, or Rev. Proc. 2002-9.

Depreciation schedule said...

The main purpose of this is to get your property ready for a tenant to move in as close to the settlement date as possible. In order for your leasing agent to get a tenant for you, they would require at least 2 weeks to advertise and to organise open house inspections for you.