Qualifying taxpayers have long been able to deduct the business use of a portion of their residence when calculating income tax. But the Internal Revenue Service (IRS) and taxpayers are at odds regarding the qualifications required to take the deduction as well as identifying the proper amount to use in calculating it. Revenue Procedure 2013-13 created a second, optional method for calculating the deduction.
This simplified method is actually a safe harbor that provides a set rate of $5 per square foot for up to 300 square feet of qualified use. It should alleviate issues in the calculation of the deduction for some taxpayers. Using it, however, doesn’t change the initial qualification requirements to be eligible for the deduction.
The general provisions of IRC §280A deny business deductions related to a home or dwelling that the taxpayer also uses as a residence, except for personal items specifically allowed, such as mortgage interest and real property taxes. In order for the dwelling to qualify for business use, the part of the home used in the business must be a separate structure used in connection with the business, or it must be used exclusively and regularly as the principal location for the business or as a place used by patients, clients, or customers in meeting with the taxpayer. In the case of a taxpayer claiming an unreimbursed employee expense deduction, these rules apply only if the business use of the portion of the dwelling is for the convenience of the employer.
The home office deduction under the actual or simplified method can’t be used to create a net loss for the business. Under the actual method, the excess is carried over to the following year. Under the simplified method, deduction amounts in excess of income for the business activity may not be carried forward, nor may amounts carried forward from a previous year be added to the simplified safe harbor amount.
The taxpayer can’t use actual expenses in a year in which the simplified safe harbor method is chosen. Similarly, an employee can’t use the safe harbor method if he or she receives a reimbursement from the employer. A qualifying taxpayer chooses whether to use the safe harbor method in place of actual expenses on an annual basis and can change that choice from year to year. The election is made simply by using the safe harbor method on a timely filed return.
The safe harbor only replaces the actual home office deduction. It doesn’t prevent the taxpayer from deducting other business expenses of that business. A convenient side benefit of this safe harbor is that expenses that would normally be allocated between the home office use and itemized deductions, such as mortgage interest, are no longer allocated and may be deducted in full as itemized deductions. Business deductions for depreciation for the home office aren’t allowed in a year in which the safe harbor is used. The rule provides that depreciation for a safe harbor year is deemed to be zero.
Claiming the actual home office deduction involves filing Form 8829 in conjunction with the taxpayer’s Schedule C for the business. Employees use Form 2106 to report employee-related expenses. Taxpayers choosing the safe harbor method simply fill in the information for the home office on the appropriate line of the Schedule C. Instructions for completing Schedule C include a worksheet for the simplified home office deduction. A potential complication exists if the taxpayer chooses in a subsequent year to go back to using actual expenses after using the safe harbor deduction. In that later year, the taxpayer must use the optional depreciation table even if he or she hadn’t used it previously.
For example, assume the taxpayer has a 2,000-square-foot home and uses 200 square feet of this home for a qualifying home office. The taxpayer has mortgage interest and real estate taxes related to the home totaling $4,000 for that year. The cost of the home exclusive of land is $200,000, and the taxpayer has chosen to depreciate the property using the alternative depreciation system life of 40 years. Therefore, the depreciation expense for the entire home for the year would be $5,000. Assume that the cost of utilities and other indirect expenses related to the office is $3,000. There are no direct expenses for the year, and the taxpayer’s business income is sufficient to allow for a deduction under either method.
Using the standard method, the 10% of the home used for business (200 square feet divided by 2,000 square feet) moves $400 of interest and taxes from Schedule A to the home office deduction. Also, $300 (10%) of the indirect expenses and $500 (10%) of the depreciation are allowed as part of the home office deduction. The total home office deduction, therefore, is $1,200.
If the taxpayer uses the simplified safe harbor method, the expense would be 200 square feet times $5 per square foot for a total of $1,000, and the taxpayer would retain the $400 of interest and taxes on Schedule A. Thus, under the safe harbor method, the taxpayer has a total of $1,400 of deductions compared to $1,200. This assumes the taxpayer benefits from itemized deductions. In addition, using the safe harbor method doesn’t reduce the taxpayer’s basis in the home.
Taxpayers who qualify for the home office deduction and use a relatively small home office may benefit from the simpler compliance associated with the optional method. This may minimize conflicts with the IRS over whether certain specific expenses are deductible since it uses a standard rate per square foot.
To qualify for the home office deduction, regardless of which method is used to calculate it, the part of the home used in the business must be exclusively used on a regular basis as:
* the principal place of business for any trade or business of the taxpayer,
* a place of business that’s used by patients, clients, or customers in meeting or dealing with the taxpayer in the normal course of trade or business, or
* be a separate structure that isn’t attached to the dwelling unit and is used in connection with the taxpayer’s trade or business.
© 2015 A.P. Curatola