Real estate business expenses are tax deductible if they are:
- ordinary and necessary;
- directly related to their business; and
- reasonable in amount. [26 United States Code §162]
An ordinary expense is an expense that is common and accepted in a trade or business.
A necessary expense is an expense that is helpful and appropriate for the business. However, an expense does not need to be required to be considered necessary. [IRS Publication 17]
For example, when a licensed broker’s or agent’s income is solely passive or portfolio type income, a real estate license is not necessary or required to manage these investments. Here, expenses such as the state licensing fee are not considered expenses necessary to these investments. Thus, the fee is not tax deductible since these income category investments are not a trade or business activity.
Personal expenses, such as the cost of a home computer used for paying bills, gaming, or other personal purposes, are not deductible as business expenses.
When an item is purchased for both personal and business use, such as a cell phone, only the business portion of the expense may be deducted. For example, when the cell phone is only used 50% of the time for business, then only 50% the cost of the phone and its ongoing service may be deducted as a business expense.
The Internal Revenue Service (IRS) does not limit the total amount that may be deducted, as long as the amount is reasonable. As a general rule, an expense is considered reasonable when more economical and practical ways to achieve the same result do not exist.
If the IRS deems the deductions as unreasonable, it will disallow only the portion it finds unreasonable, if not the entire deduction. [26 USC §162]
Common business expenses for real estate brokers and agents include:
- agent and employee compensation – including fees, wages and benefits;
- the California Bureau of Real Estate (CalBRE) license fee (broker or salesperson) [IRS Publication 529];
- business meals and business-related entertainment (50% deductible) [IRS Publication 463];
- client closing gifts, such as wine (up to $25 per person annually) [IRS Publication 463];
- continuing education (CE), seminars and training to maintain a license or improve real estate-related skills [More on education expenses on Card 2];
- computers used for business;
- computer software, such as office management programs;
- desk fees;
- home office expenses [IRS Publication 587; More on home office expenses on Card 3];
- individual retirement account (IRA) contributions (except Roth IRA contributions) [26 USC §4975(e)(1)];
- insurance – including health, errors and omissions (E&O), business liability and business equipment insurance;
- interest on business loans and business credit cards;
- internet service fees;
- marketing expenses – including newspaper, magazine and online advertising, websites, domain registration, mailing lists, flyers, promotional materials, signs and clothing containing business logos or other branding material;
- office equipment [IRC Section 179];
- office expenses – including rent, maintenance and utilities;
- office supplies;
- open house expenses, such as food and drink;
- postage, such as for marketing and FARM letter materials;
- professional membership fees – including multiple listing service (MLS), trade union and Chamber of Commerce membership dues;
- professional services fees – including bookkeeping, accounting and legal;
- referral fees paid to other brokers;
- real estate franchise fees;
- subscriptions – including professional journals and periodicals;
- taxes – including payroll taxes for employees, state and local business taxes;
- telephone service (both landline and cellular);
- travel expenses for business conventions and training – including lodging, meals, parking, tolls and transportation [IRS Publication 463]; and
- vehicle expenses – including business mileage, depreciation, insurance, interest on car loans, lease payments, Department of Motor Vehicles (DMV) registration fees, vehicle maintenance (either the actual expenses or the Standard Mileage Rate). [IRS Publication 463]
The costs of work-related real estate education are tax deductible as business expenses.
However, the education only meets the requirements as a tax deductible expense when it:
- is required by law or regulation to maintain a professional status; or
- maintains or improves skills needed in the licensee’s present trade or business. [IRS Publication 17]
Thus, CE required to maintain and renew a real estate broker or agent license and any education that helps improve skills, such as real estate seminars (even though they are not required to maintain a license) is tax deductible as a business expense.
However, the costs of educational courses taken to qualify and obtain either a real estate salesperson’s or broker’s license are not tax deductible.
When education is part of the educational requirements to become licensed for a trade or business, or qualifies an individual for a new trade or business, the education is not work-related education. Thus, its cost is not tax deductible. [IRS Publication 17]
The cost of education required to become a broker, even when taken by an active licensed agent, is similarly not a deductible expense of doing business.
A licensed broker is permitted to perform significantly different tasks and activities than those performed by an agent. As such, broker licensing courses, similar to agent licensing courses, are prerequisites for a new trade or business, a different license from the one needed by an agent to continue in business. [Goldstein v. C.I.R., 52 TCM 1481 (1987)]
Further, the fee for the state exam, whether the salesperson’s or broker’s, is not a business expense and is not tax deductible. However, the actual CalBRE license fee is, as a cost of doing business. [See Figure 1]
However, reporting real estate business losses which include home office expenses are limited by the IRS. Losses cannot be reported to the extent they contain home office expenses. Thus, no portion of the trade or business loss reported can be home office expenses. [King v. Commissioner TC Memo 1996-231]
Home office deductions are further limited as follows:
- a set portion of the home is used exclusively and regularly for the licensee’s brokerage business;
- the expenses may be direct or indirect; and
- the use of the home office meets one of three business activity standards.
Brokers and sales agents who report to state and federal taxing authorities as independent contractors (ICs) qualify for the home office deduction. Their deductible home office expenses include:
- the direct expenses attributable to the home office area used exclusively in the business; and
- the indirect expenses, which are limited in amount to the percentage of the area in the residence that is used as the home office.
Direct expenses, deductible as a brokerage business expense, include the cost of decorating and repairs made in the portion of the residence exclusively used as the home office.
The entire amount of direct expenses is deductible from business income without allocation for the personal use of the remaining space in the residence.
Indirect expenses are costs incurred in the upkeep and operation of the licensee’s entire residence, including:
- rent paid as a tenant;
- mortgage interest;
- real estate taxes;
- home insurance;
- utilities; and
- maintenance. [IRS Publication 587]
The portion of indirect expenses deductible as a business expense is equal to the percentage of the residence used as the home office. [Proposed Revenue Regulations §1.280A-2(i)(7)]
Expenses incurred for activities outside of the dwelling, such as for lawn care, pool maintenance or tree trimming, are considered personal expenses and cannot be deducted as business expenses. Further, expenses incurred on the inside of the house that are unrelated to the home office area are personal and not deductible, such as the remodeling or maintenance of any area other than the home office area. [Prop. Rev. Regs. §1.280A-2(i)(7)]
In lieu of ownership expenses, when the licensee is a tenant in a home or apartment they use in part for their office, they may write off a pro rata amount of the rent as a business expense. [Visin v. Commissioner (2003) 86 TCM 279]
The area in the licensee’s residence set aside for the home office needs to be used exclusively for the brokerage business. Personal use of the area, such as the use of a family room to watch TV in the evenings or to occasionally entertain guests on weekends, does not qualify for the home office deduction. [26 United States Code §280A(c)(1)]
In addition to the home office area being dedicated exclusively to business activities, the home office needs to be used regularly by the licensee for conducting their business.
For example, a licensee who uses the home office four or five days each month in the evening to catch up on work they were unable to complete at their nonresidential office may not take a deduction for home office expenses. The fact that it is used exclusively for their business is not solely decisive since the exclusive use needs to be coupled with regular use.
If the licensee meets the exclusive and regular use tests, the home office use also needs to qualify for one of three business activity standards to take the allowable deductions.
These business activity standards require a licensee to establish they conduct business at the home office, by meeting one of the following tests:
- the home office is used as a place of business to meet or confer with clients;
- the home office is located in a separate structure not attached to the residence; or
- the home office is the principal place of business for the licensee. [26 USC §280A(c)(1)(A-C)]
The licensee who uses the home office to regularly meet and confer with clients is allowed to deduct home office expenses from their brokerage income. The licensee needs to document the client conferences by keeping a calendar or log book showing:
- the names of their clients;
- the date of each meeting with the clients at the licensee’s home office; and
- what they discussed or acted upon.
The home office located in a structure separate from the licensee’s residence also qualifies for the deduction of business expenses. Examples include a(n):
- detached garage apartment;
- granny flat; or
In addition, a depreciation deduction may also be taken on the portion of the residence used as the home office, known as a mixed use property. However, on the future sale of a mixed use property comprised of the licensee’s principal residence and a separate space used as their home office, the portion of the cost basis allocated to the home office is subject to unrecaptured depreciation gains for all depreciation deductions taken.
When the licensee does not use the home office to meet or confer with clients, or the home office is not located in a separate structure, the licensee may demonstrate the home office is their principal place of business and qualify for the home office deduction.
For a home office use to be classified as their principal place of business, the licensee needs to perform most of or the most important of their brokerage activities while working in the home office.
The importance of the activities conducted at the home office and the time spent carrying out those activities establishes the home office as their principal place of business.
When a licensee has a nonresidential office for professional reasons in addition to a home office, they may still qualify for the deduction of home office expenses when the most important part of their work (soliciting, conferring, setting appointments, preparing documents and packaging transactions) takes place at the home office. [Beale v. Commissioner TC Memo 2000-158]