Home Office Deduction
NEW FOR 2013 AND LATER YEARS
Simplified Option for Home Office Deduction
Do you work from home? If so, you may be familiar with the home office deduction, available for taxpayers who use their home for business. Beginning this year, there is a new, simpler option to figure the business use of your home.
This simplified option does not change the rules for who may claim a home office deduction. It merely simplifies the calculation and recordkeeping requirements. The new option can save you a lot of time and will require less paperwork and recordkeeping.
Here are six facts the IRS wants you to know about the new, simplified method to claim the home office deduction.
- You may use the simplified method when you file your 2013 tax return next year. If you use this method to claim the home office deduction, you will not need to calculate your deduction based on actual expenses. You may instead multiply the square footage of your home office by a prescribed rate.
- The rate is $5 per square foot of the part of your home used for business. The maximum footage allowed is 300 square feet. This means the most you can deduct using the new method is $1,500 per year.
- You may choose either the simplified method or the actual expense method for any tax year. Once you use a method for a specific tax year, you cannot later change to the other method for that same year.
- If you use the simplified method and you own your home, you cannot depreciate your home office. You can still deduct other qualified home expenses, such as mortgage interest and real estate taxes. You will not need to allocate these expenses between personal and business use. This allocation is required if you use the actual expense method. You’ll claim these deductions on Schedule A, Itemized Deductions.
- You can still fully deduct business expenses that are unrelated to the home if you use the simplified method. These may include costs such as advertising, supplies and wages paid to employees.
- If you use more than one home with a qualified home office in the same year, you can use the simplified method for only one in that year. However, you may use the simplified method for one and actual expenses for any others in that year.
The Taxpayer Relief Act of 1997 included a modification of the IRS’s definition of “principal place of business” that will permit a larger number of taxpayers to qualify for the home-office deduction. For tax years beginning after 1998, the deduction will be available for home offices that are used for administrative or management activities related to the taxpayer’s business (for example, billing, maintaining records, ordering supplies, scheduling appointments, creating reports).
This is a difficult deduction to sustain on an examination (audit). This page is intended to give you some general information that may help you decide if you qualify for the deduction, and if you do qualify, if you really want to take it (for reasons discussed below).
Business versus Personal Usage
Home-based businesses, by their very nature, often have less structure. While many consider this to be an advantage, working at home can be a double-edged sword. The lack of structure tends to result in home-based workers putting in more hours than when they did not work at home. Having set office hours and “closing up” at the end of the day will help you balance business and personal matters.
Under the amended rules, a taxpayer is allowed to deduct expenses of a home office that is used for business purposes only if the space is used “exclusively” on a “regular basis” as:
The principal place of business carried on by the taxpayer,
- A place for meeting with clients or customers in the ordinary course of business, or
- A place for the taxpayer to perform administrative or management activities associated with the business, provided there is no other fixed location from which the taxpayer conducts a substantial amount of such administrative or management activities.
The Taxpayer Relief Act of 1997 added this third provision to the definition of principal place of business:
The exclusive-use test will be satisfied if a specific portion of the taxpayer’s home is used solely for business purposes or inventory storage. The regular-basis test is satisfied if the space is used on a continuing basis for business purposes (that is, incidental business use will not qualify.
In determining the principal place of business (first provision under the definition of principal place of business, above), the IRS considers two factors: Does the taxpayer spend more business-related time in the home office than anywhere else? Are the most significant revenue-generating activities performed in the home office? Both of these factors must be considered when determining the principal place of business.
To qualify for the home-office deduction, an employee must satisfy two additional criteria. First, the use of the home office must be for the convenience of the employer (for example, the employer does not provide a space for the employee to do his/her job). Second, the taxpayer does not rent all or part of the home to the employer. Employees who telecommute may be able to satisfy the requirements for the home-office deduction.
Home office expenses are classified into three categories:
Direct Business Expenses relate only to the taxpayer’s business activity (for example, supplies, salaries). Expenditures for additional phone lines, long-distance calls, and optional phone services for the business may be deductible as direct business expenses. However, basic local telephone service charges (that is, monthly access charges) for the first phone line in the residence generally do not qualify for the deduction.
Permissible Expenses are expenditures that could be included as itemized deductions in the individual’s tax return (for example, mortgage interest, real estate taxes, and casualty losses).
Previously Non-deductible Expenses would not be deductible if not for the home office deduction (for example, insurance, utilities, and depreciation).
You can take a depreciation deduction for the business portion of your residence. A home office is deemed nonresidential real property – depreciated at a straight-line rate over 39 years (not the 27.5 used for residential rental properties). The basis of the home when first used for business is generally (a) the original cost, PLUS (b) improvements (like room additions, new roof, etc), LESS the cost of the land (use the property tax bill at time of acquisition to allocate the purchase price between land (not depreciable) and improvement (the dwelling – which is depreciable), LESS any casualty loss(es) claimed in excess of insurance reimbursement. Then, once the depreciable basis is determined, the annual depreciation is calculated using the business percentage of use (e.g., 10% of the home) TIMES the annual depreciation TIMES (the number of months used for business in the year DIVIDED BY 12).
NOTE – if at the time of first business use the fair market value (FMV) of the house is LESS than its basis (as calculated above), then use the FMV in stead of the cost basis. This will lead to a smaller (but accurate) depreciation deduction.
Home office deductions are limited to the net income from the business activity. Previously non-deductible expenses cannot create or increase a net loss from a business activity. However, a carryover to future years is available for unused, allowable home-office expenses.
Sale of Residence
Tax rules generally permit a $500,000 (married filing jointly) or $250,000 (single or married filing separately) exclusion on the gain from the sale of a primary residence. Under prior law, if part of the home is used for business purposes, the gain was divided into two parts — personal-use portion (the exclusion applies) and business-use portion (exclusion does not apply). For example, a taxpayer who qualifies for the exclusion, but has used 25 percent of the home for business purposes during the during past five years, will only be able to apply the exclusion against 75 percent of any gain recognized on the sale of the home. The resulting taxable gain on the 25% portion may exceed by many times to tax savings achieved through a home office deduction!
Effective in December, 2002, this has been changed. Now, if you sell your residence and you were deducting depreciation on a portion used as an office in the home (or for storage), then you must recapture the depreciation you claimed over the past years. The net result is that you are usually better off having claimed the depreciation in previous years as the tax benefit likely outweighs the tax you will have to pay in its recapture (at capital gain rates).
The “office-in-home” tax deduction is valuable because it converts a portion of otherwise nondeductible expenses (for example, utilities and homeowners insurance) into a deduction. For self-employed individuals, the home office deduction can reduce your self-employment tax (generally 15.3% of your net profit up to the FICA limitation). The treatment of home offices for income tax purposes is one of the more controversial provisions in the tax law.
An individual is not entitled to deduct any expenses of using his/her home for business purposes unless the space is used exclusively on a regular basis as the “principal place of business.” The IRS applies a 2-part test to determine if the home office is the principal place of business.
Do you spend more business-related time in your home office than anywhere else?
Are the most significant revenue-generating activities performed in your home office?
If the answer to either of these questions is no, the home office will not be considered the principal place of business, and the deduction will not be available.
Business use of the home by an employee must also be for the convenience of the employer. These rules make it very difficult for an employee to qualify for the deduction. Almost always, the IRS WILL require a letter from the employer attesting to the required use of a home office because space is NOT provided at the company’s offices.
If these three tests are met, the deduction is limited to the gross income from the business activity. A deduction for home-office expenses cannot create or increase a net loss from the business. However, any unused deduction may be carried over to future years.
Taxpayers taking a deduction for business use of their home must complete Form 8829. Be aware that taking a deduction for home-office expenses, whether clearly allowable or not, increases the likelihood of an IRS audit.
2015 TAX COURT CASE
Home Office Deduction Fails Exclusive Business Use Test: A sole proprietor of a vascular ultrasound business claimed a home office deduction on his Schedule C for expenses allocable to his living room, where he was developing a laboratory and staffing agency. Because the only way to access other rooms in the house was through the living room, and the individuals who lived in the house used that room for other family activities, the space wasn’t used exclusively for business, which is required for the deduction under IRC Sec. 280A(c)(1). Therefore, the home office deduction was disallowed. Arunas Savulionis, TC Summ. Op. 2015-19 (Tax Ct.).
2011 IRS NOTICE
In March, 2011, the IRS issued the following “tax tips” concerning home office deductions:
Work From Home? Consider the Home Office Deduction
Whether you are self-employed or an employee, if you use a portion of your home for business, you may be able to take a home office deduction. Here are six things the IRS wants you to know about the Home Office deduction
1. Generally, in order to claim a business deduction for your home, you must use part of your home exclusively and regularly:
- as your principal place of business, or
- as a place to meet or deal with patients, clients or customers in the normal course of your business, or
- in any connection with your trade or business where the business portion of your home is a separate structure not attached to your home.
2. For certain storage use, rental use, or daycare-facility use, you are required to use the property regularly but not exclusively.
3. Generally, the amount you can deduct depends on the percentage of your home used for business. Your deduction for certain expenses will be limited if your gross income from your business is less than your total business expenses.
4. There are special rules for qualified daycare providers and for persons storing business inventory or product samples.
5. If you are self-employed, use Form 8829, Expenses for Business Use of Your Home to figure your home office deduction and report those deductions on line 30 of Form 1040 Schedule C, Profit or Loss From Business.
6. If you are an employee, additional rules apply for claiming the home office deduction. For example, the regular and exclusive business use must be for the convenience of your employer.
For more information see IRS Publication 587, Business Use of Your Home, available at http://www.IRS.gov or by calling 800-TAX-FORM (800-829-3676).