The Changing Home Office Deduction
As technology advances and the professional landscape continue to evolve, the use of a home office is increasingly common. The U.S. Census Bureau has reported that over 50% of all U.S. businesses now operate primarily from someone’s home.
The Internal Revenue Service (IRS) allows a deduction for business use of a home if two basic criteria are met pursuant to Internal Revenue Code (IRC) section 280A(c)(1) through (4). First, the home office must be the taxpayer’s principal place of business. This may be satisfied by the use of a home office for substantial administrative activities, such as bookkeeping and scheduling appointments; as well as a place to meet or deal with patients, clients, or customers to discuss business engagements or sign contracts.
The second criteria is that the home office must be used regularly and exclusively for business. The home office deduction can apply to any “portion” of a home meeting these criteria and need not be an entire room or physically separated area. However, taxpayers should be aware that the absence of an identifiable physical separation is a factor that the IRS will use to determine whether the space is used exclusively for business.
For example, the Tax Court has allowed a deduction for a specific portion of a taxpayer’s bedroom set up with a desk, chair, file cabinets, and bookcase when the bed and dresser were in a separate distinct area, even though there was no physical wall or other partition separating the “business” area. However, the Tax Court denied a deduction for the use of a portion of an apartment by the taxpayer, a clinical psychologist, to see patients, because that portion was simply an open area that was also used as a main passageway through the apartment.
Statistics show that in 2010, the most recent year for which data is available, approximately 3.4 million taxpayers claimed the home office deduction on their federal income tax return.
However, many business owners working from home decline to take any home office deduction for fear of attracting IRS scrutiny, because the home office deduction has commonly been considered an audit red flag. Another deterrent for taking this deduction is that it can be an administrative nightmare for taxpayers to maintain the records necessary to claim and substantiate the deduction.
The IRS and the Department of the Treasury have finally recognized the recordkeeping and compliance burdens associated with determining the allowable home office deduction and have offered a more simplified option. The IRS announced on January 15, 2013, in accordance with Revenue Procedure 2013-13, there will be a safe harbor method that taxpayers may elect to use to determine their allowable deduction for business use of a home.
At the time of the announcement, acting IRS Commissioner Steven T. Miller said, “This is a common-sense rule to provide taxpayers an easier way to calculate and claim the home office deduction.” Revenue Procedure 2013-13 is effective for taxable years beginning on or after January 1, 2013. Thus, the new simplified safe harbor option will be available starting with the 2013 return.
The new safe harbor method is calculated by multiplying the allowable square footage of the qualified home office portion by the prescribed rate issued by the IRS and Treasury Department. The allowable square footage may not exceed 300 square feet, and the prescribed rate is currently set at $5.00; thus the safe harbor deduction is currently capped at $1,500 per year.
The IRS and Treasury Department have the authority to update the prescribed rate at their discretion. In addition, the deduction under the new safe harbor method may not exceed the gross income from the business use of the home (reduced by otherwise allowable business deductions) and may not be carried over and claimed as a deduction in any other tax year.
A taxpayer elects the safe harbor approach by simply using this method on their timely filed, original federal income tax return. The election is irrevocable in the year of the election; however the election is made on a year by year basis. For example, a taxpayer can choose to use the safe harbor method in 2013 and then deduct actual expenses in 2014. It should also be noted that a change from the safe harbor method to the actual expense method or vice-versa is not a change in accounting method and does not require the consent of the Commissioner.
The safe harbor method restricts the taxpayer from deducting any actual expenses related to the qualified business use of the home for that taxable year. Such allocable expenses could include, but are not limited to, utilities, maintenance & repairs, real estate taxes, and mortgage interest. However, a taxpayer who itemizes deductions is still allowed a deduction on Schedule A for 100% of otherwise deductible expenses such as mortgage interest and property taxes.
In addition, taxpayers are still entitled to a deduction for any trade or business expenses unrelated to the home office deduction such as advertising, wages, and supplies. Conversely, depreciation and Section 179 expenses are disallowed as a deduction in any year that the safe harbor method is elected. As a result, the taxpayer should continue to keep records of depreciation to ensure that the correct depreciation expense is taken in future years in which actual expenses are deducted as opposed to the safe harbor method.
Taxpayers should assess their situation annually to consider which alternative is the most beneficial. Some factors to keep in mind are:
• The taxpayer’s qualified home office is larger than 300 square feet
• Their records show their actual expenses exceed $1,500
In these cases, they may be losing the benefit of deductions available by using their actual expenses. On the other hand, if the taxpayer hasn’t kept good records, or their qualified space is less than 300 square feet, the safe harbor method may be more appropriate.
The safe harbor method gives taxpayers a simplified option for claiming the home office deduction. How positively taxpayers respond to this new option should become evident as we move into the 2013 filing season. At the very least, taxpayers should be aware of the alternatives, and conservative taxpayers should view this as a more reliable choice for taking a home office deduction with less concern of audit exposure.