Earlier this year, the Internal Revenue Service announced a new, simplified, optional method of claiming a home office deduction. For the last year that the IRS released information, about 3.4 million people filed Form 8829 with their tax returns to claim a deduction for the business use of their home in 2010. The new, simplified method is based on deduction of $5 per square foot, for up to 300 square feet. This “safe harbor” deduction method is limited to a maximum deduction of $1,500 per year.
The IRS will be publishing a significantly simplified form, which is expected to reduce paperwork and record keeping for small businesses by an estimated 1.6 million hours each year. While you can still use the old rules if they provide a more favorable result, it is anticipated that many taxpayers will opt for the ease of the new method. This new option is applicable beginning with the filing of 2013 tax returns. In the future, the IRS may update this rate as conditions and inflation may dictate.
If you use the new method, you will not be allowed to depreciate the portion of your home used in your trade or business. However, you will be able to claim 100 percent of your allowable mortgage interest and real estate taxes as itemized deductions without the need to allocate these expenses between personal and business use, as is currently required under the regular method.
This effectively increases your overall home office deduction by moving these expenses from your office in the home deduction back to itemized deduction on your Schedule A. Additionally, you can deduct expenses that are not related to the home, such as materials, supplies and other expenses, under either new or the regular methods.
Each taxpayer may claim the safe-harbor deduction for more than one business, but the total deduction is still limited to a maximum of 300 square feet. In this case, you may allocate the deduction between the various businesses in any reasonable manner. However, if you are married, you may each claim this deduction for different portions of your home for a maximum deduction of $3,000.
The safe harbor method is an election that is made simply by claiming the deduction using $5 per square foot on the applicable tax form. Although the use of the method is irrevocable for that tax year, you can decide between the regular and the safe harbor methods each year, using whichever gives you the greatest deduction. In determining which method is best for you, remember to consider the effect of the alternative minimum tax, and the self-employment tax.
It is important to note that the new method retains the restrictions under the regular method, that a home office be used regularly and exclusively for business. In order to pass the tests for deductibility of home office expenses, you must meet at least one of the following:
- The home office is used exclusively and regularly as your principal place of business.
- You regularly use the home office as a place to meet with clients, patients or customers in the normal course of business.
- The home office is a separate structure that is used in connection with your trade or business.
In addition, there are special rules that allow a deduction for business use of your home if used for either:
- Storage of inventory or product samples
- Certain day care facilities
However, if you are an employee, the home office must be for the convenience of your employer. So if your employer allows you to work from home, the deduction may not be allowed if it is for your convenience rather than that of your employer.
An outside salesperson who is not provided an office at his employer’s primary place of business should be allowed a home office deduction, while an employee who is furnished an office by his employer generally cannot deduct expenses for a home office that he has as a matter of personal preference or convenience.
Many taxpayers have the deduction disallowed by the IRS because they fail to meet the first rule above, that the space must be used exclusively for business purposes. An individual who uses his home office for a part-time business that otherwise would meet the above tests, but also uses the home office to do work for his regular employer, to work on a hobby or to manage his personal finances will not qualify for the deduction.
As a general rule, if you operate a business out of your home, nonbusiness activities must be done in a different part of your house, or you risk losing your deduction. Converting a spare bedroom to an office is fine, but you cannot occasionally use it for guests and still claim the deduction.
The IRS does not require that the home office space to be physically distinct or separated by walls in order to qualify. It is fine to use a portion of a room as long as it is separately identifiable and, as noted above, used exclusively for business.
You should note that if you are planning on claiming a home office, it is important to consider whether you possibly plan to sell your house in the near future. The rules for the exclusion of gain on the sale of the home may be complicated by claiming a deduction for your home office under either the regular or safe harbor methods.
In order to exclude all or a portion of the gain on the sale of your principal residence, you are required to use the home two out of the last five years as your principal residence. If you claim a home office deduction for use of your house for more than three years out of the five-year period prior to the sale of the house, you may lose a portion of the exclusion applicable to the part of the house used for your home office.
If you think you may be required to pay a big tax bite on the sale of your house, you may want to pass up on the home office deduction. Items you should consider are the effect of capital gains and potential prior depreciation that needs to be recaptured as ordinary income.
Burton S. Speer is a partner in the tax department at Mengel, Metzger, Barr & Co. LLP, and can be reached at Bspeer@mmb-co.com or (585) 423-1860.