This article was first published in the fourth-quarter 2014 edition of Personal Finance magazine.
Few people are aware of the interesting interplay between income tax and capital gains tax (CGT) that results from having a home office. Although you may be eager to know what you have to do to qualify for a tax deduction in respect of home-office expenses, it is equally important to understand the negative CGT consequences that result from using a portion of your home for business purposes.
Home-office expenses qualify for a deduction from income tax if a number of requirements are met, and these are spelled out in sections 11 and 23 of the Income Tax Act. They can be summarised as follows:
* A portion of your home must be occupied for the purposes of trade;
* That portion must be regularly and exclusively used for the purposes of such trade; and
* That portion must be exclusively equipped for the purposes of such trade.
But if that “trade” arises from your being an employee, or holding an office for which you earn an income, a tax deduction will be permitted only if:
* More than 50 percent of your total income is based on commissions, or variable performance payments resulting from that employment; and
* Your work is usually performed in that part of your home and not in an office provided by your employer.
Ordinary employees are therefore unlikely to qualify for a deduction, because they would receive a predetermined salary and/or work at their employer’s place of business.
Assuming, however, that you meet the criteria, what specific expenses qualify for deduction? According to the South African Revenue Service’s interpretation note on the matter, typical home-office expenses are:
* The rental paid in respect of the premises;
* The interest on your mortgage bond;
* The cost of repairs to the premises;
* Other expenses in connection with the premises;
* Municipal rates and taxes;
* Electricity and telephone expenses;
* Cleaning; and
* Office equipment, and wear and tear thereon.
Where the expense is a determinable and specific business expense, such as stationery, the whole cost is deductible. If, on the other hand, the expense relates to the property as a whole, such as rates and taxes or rental, the expense has to be apportioned. This apportionment is done by multiplying the expense by a fraction arrived at by taking the floor space of the home office over the total floor space of the house.
For example, if the rental is R60 000 for the year and the floor area of the office is 40 square metres, while the floor area of the entire house is 400 square metres, the deduction in respect of the rental is calculation as follows: R60 000 x 40 ÷ 400 = R6 000.
Unwanted CGT consequences
Homeowners are afforded a considerable measure of tax relief in respect of the capital gains resulting from the sale of their primary residence. The Income Tax Act provides for a primary residence in its 8th Schedule. The lesser-known flip side of this generosity is that the Act also excludes a portion of the capital losses that the taxpayer may incur on the sale of his or her home. The capital gain or loss on any property of less than R2 million is excluded entirely, while the first R2-million capital gain or loss in respect of a home of more than R2 million in value is excluded.
However, if any part of the home was used for business purposes for any period of time after the introduction of CGT on October 1, 2001, the Income Tax Act requires that the capital gain or capital loss that results from the disposal of the residence must be apportioned between such residential and business use. This apportionment must take into account the period during which the home was used for business purposes (as a fraction of the entire period during which the property was owned), as well as the extent of the property (as a fraction of the whole) that was used for this purpose. In other words, the Act requires two apportionments to be done.
The following example illustrates the apportionment. Yolande bought her residence on October 1, 2003. Her base cost was R500 000. On October 1, 2008, Yolande started a financial and legal consulting practice, which she operated from her home. About 35 percent of the residence’s floor space was used for this purpose. Yolande also claimed 35 percent of her costs as a business against her business income for income tax purposes.
In October 2011, Yolande decided to expand her business. This required that she use the entire property for the business. She accordingly purchased a property in which to live and converted the old residence into business premises, at a cost of R800 000.
On September 30, 2013, Yolande sold the property for R3.7 million. The CGT calculation is as follows:
Proceeds on disposal: R3.7 million
Less: base cost: R1.3 million (R500 000 + R800 000)
Capital gain: R2.4 million
Less: apportionment for the period (two years) during which the property was used exclusively for business purposes: R480 000 (R2.4 million x 2 ÷ 10)
Less: apportionment for the period (three years) during which the property was partially used for business purposes: R252 000 ([R2.4 million x 3 ÷ 10] x 35 percent)
Portion of the capital gain attributable to the property’s use as a primary residence: R1 668 000 (R2.4 million – [R480 000 + R252 000])
The gain of R1 668 000 is less than the exclusion of R2 million provided for by paragraph 45(a) and is therefore not subject to CGT. The portion of the capital gain attributable to Yolande’s use of the property as a business premises is R732 000 (R2.4 million – R1 668 000). This R732 000 must be aggregated with any other capital gain or loss that Yolande may have made in the year of disposal. (For the purposes of this article, it is assumed that there was no other gain or loss.)
The aggregated amount of R732 000 must then be reduced by the annual exclusion of R30 000, which leaves an aggregated capital gain of R702 000. From this aggregated capital gain must be deducted any assessed capital loss that Yolande may have carried forward from any previous year of assessment, resulting in a net capital gain or assessed capital loss for the year. (Once again, it is assumed that there was no capital loss to carry forward.) Accordingly, Yolande’s net capital gain for the year is R702 000. This is multiplied by her inclusion rate of 33.33 percent, leaving her with a taxable capital gain of R233 976.60, which will be taxed at her marginal rate of tax. If we assume that Yolande is on a marginal rate of tax of 40 percent, the tax payable is R93 590.64.
This article is not intended to suggest that you should not avail yourself of the income tax deductions that may be available to you when using your residential property for business purposes. Instead, it is an alert, if you plan to practise from home or are doing so already, that a home becomes tainted as a result of any portion of it being used for the purpose of trade. It is important to remember, too, that once a property is so tainted, it is irrelevant (i) whether you are or were entitled to a deduction in respect of home-office expenses, and (ii) whether or not you actually claimed such a deduction.
* Franscois van Gijsen is a member of the Fiduciary Institute of Southern Africa and the director of legal services at Finlac Risk and Legal Management.