United States: An Easier Way To Calculate The Home Office Deduction

To claim a deduction for home office expenses, taxpayers are required to fill out Form 8829, Expenses for Business Use of Your Home, which consists of 43 lines, and to perform a number of complex calculations of allocated expenses, depreciation, and carryover of unused deductions. Private industry has argued that the rules for the home office deduction are too complex. To simplify the process, the National Taxpayer Advocate recommended that Congress create an optional standard home office deduction based on a simple formula. Along those lines, numerous bills have been introduced that provide a simple formula for calculating the home office deduction.

In Rev. Proc. 2013-13, the IRS announced a new simplified option beginning in 2013 for individuals to use in determining the home office deduction amount. This option does away with the previously required calculation, allocation, and substantiation of actual expenses.

Background

The general rule is that no deduction is allowed for the business use of a dwelling that is also used as a residence during the tax year. However, certain exceptions apply, allowing for the deduction of expenses allocated to the business use of a residence.

Exclusively and regularly

To qualify for the deduction, the home office must be used "exclusively and on a regular basis" as the principal place of business for any trade or business, as a place to meet clients or customers in the normal course of a trade or business, or in the case of a separate structure not attached to the taxpayer's dwelling unit, in connection with a trade or business (Sec. 280A(c)(1)). "Used exclusively" means that the home office must be used only for business, not personal, purposes.

The two exceptions to the exclusive use requirement are: (1) space used to store inventory or product samples for a wholesale or retail trade or business located in the home (if the home is the taxpayer's sole fixed location of doing business) and (2) the part of a home used in a trade or business of operating a day-care facility. The "regular basis" requirement means that the use is continuing, ongoing, and recurring and not occasional or incidental. The use must be for a trade or business, and not simply for profit-seeking activities, such as investing.

Principal place of business requirement

To qualify for the home office deduction, the part of the home that is used for business must be the principal place of business. Where the home office is not the principal place of business, it may still qualify for the deduction (1) if it is where the taxpayer meets with patients, clients, or customers and the home office is substantial and integral to the conduct of the business, or (2) if it is a separate free-standing structure that is exclusively and regularly used for the business.

Deduction limitation

When a taxpayer calculates the home office expense deduction using actual business expenses, the deduction is limited to the gross income derived from the qualified business use of the home reduced by the expenses allocable to the portion of the home used as an office that are deductible whether or not the portion of the home is used as an office (e.g., qualified residence interest and property taxes) and deductible expenses of the business unrelated to the qualified use of the home (for example, office supplies). The disallowed amount of home office expenses (those that exceed the gross income limitation) can be carried over to the next succeeding tax year in which the taxpayer calculates and substantiates actual business expenses and can be deducted, subject to the same applicable limitations.

Substantiation requirement

To be eligible to deduct home office expenses, taxpayers must satisfy rigorous and time-consuming recordkeeping requirements. The IRS estimates that small businesses spend 1.6 million hours annually on the paperwork and recordkeeping necessary to show that the area of a residence used as a home office was used regularly and exclusively as the principal place of business of the taxpayer's trade or business and to calculate and allocate expenses related to the qualified use of the home for business.

Rev. Proc. 2013-13

Safe-harbor formula

To provide taxpayers an easier way to calculate and claim the home office deduction and to reduce the administrative, recordkeeping, and compliance burdens on small businesses, the IRS announced, in Rev. Proc. 2013-13, an alternative, safe-harbor method for taxpayers who otherwise qualify for a home office deduction to determine the amount of the allowable home office expense deduction, starting in 2013.

Under the safe harbor, taxpayers will be able to compute the allowable home office expense deduction on the basis of $5 per square foot of qualifying home office space per year, up to a maximum of 300 square feet. The maximum deduction under the safe harbor is the lesser of $1,500 or the gross income derived from the qualified business use of the home. The taxpayer can elect the safe-harbor method on a year-by-year basis. The $5 per square foot rate may be adjusted by the IRS and the Treasury Department as warranted, but it is not subject to an automatic cost-of-living adjustment.

The safe harbor is not available to an employee with a home office who receives advances, allowances, or reimbursements for expenses related to the home office use under a reimbursement or expense allowance arrangement with the employee's employer.

Home definition

For purposes of the safe harbor, "home" means a dwelling unit used by the taxpayer during the tax year as a residence and includes a dwelling unit leased by the taxpayer. Only dwelling units that are generally depreciable real property or depreciable property subject to Sec. 168 that are placed in service after Dec. 31, 1986, qualify as a "home" for these purposes.

Otherwise deductible home expenses

Although taxpayers using the safe harbor cannot depreciate the portion of their home used for qualified business purposes, they can claim allowable mortgage interest, real estate taxes, and casualty losses on the home as itemized deductions on Schedule A. These itemized expenses do not have to be allocated between personal and business use of the home, as is the case for taxpayers using actual expenses to calculate the deduction, and taxpayers do not have to deduct the portion of the itemized expenses allocable to the business use of the home from the gross income derived from the qualified business use of the home for purposes of determining the gross business income limitation. As a result of not taking depreciation under the safe harbor, a taxpayer will not have to recapture depreciation upon the sale of the home, since the depreciation deduction allowable for that portion of the home used in a qualified business is deemed to be zero.

Direct expenses deductible

In addition, any business expenses unrelated to the qualified business use of the home can be deducted by a taxpayer using the safe harbor. These expenses include expenses for advertising, wages, supplies, etc.

Business gross income limitation

The amount of the deduction computed under the safe harbor is limited to the gross income derived from the qualified business use of the home reduced by the business deductions unrelated to the use of the home. To the extent that the safe-harbor amount exceeds the net income from the qualified business use of the home, it cannot be carried over to succeeding years and claimed as a deduction in any other year. This differs from the treatment of any amount of the deduction that is not deductible due to the gross income limitation in a year during which the taxpayer calculated and substantiated the actual expenses for the home office deduction. In the latter case, the excess can be carried over and deducted, subject to all other applicable restrictions, in the next succeeding tax year in which the taxpayer calculates and substantiates actual expenses for purposes of the home office deduction.

Conclusion

The new safe-harbor method undoubtedly will reduce recordkeeping and the calculation, allocation, and substantiation of actual expenses of a home office. It will also eliminate or reduce recapture of depreciation when taxpayers sell their home. However, taxpayers should make a rough calculation of home office expenses under the traditional method to compare the resulting amount with the safe harbor. Although it is more burdensome and complex, the traditional method may yield a sufficiently larger deduction (as well as permitting a carryover) and be worth the extra effort.

Thomas R. Wechter, J.D., LL.M. (Tax), is a partner with Duane Morris LLP in the Chicago office and concentrates his practice in tax planning for individuals, corporations, and partnerships and in tax controversy matters in front of the IRS and before the Tax Court, U.S. Court of Federal Claims, and the district courts.

Previously published in the AICPA Tax Insider

This article is for general information and does not include full legal analysis of the matters presented. It should not be construed or relied upon as legal advice or legal opinion on any specific facts or circumstances. The description of the results of any specific case or transaction contained herein does not mean or suggest that similar results can or could be obtained in any other matter. Each legal matter should be considered to be unique and subject to varying results. The invitation to contact the authors or attorneys in our firm is not a solicitation to provide professional services and should not be construed as a statement as to any availability to perform legal services in any jurisdiction in which such attorney is not permitted to practice.

Duane Morris LLP, a full-service law firm with more than 700 attorneys in 24 offices in the United States and internationally, offers innovative solutions to the legal and business challenges presented by today's evolving global markets. Duane Morris LLP, a full-service law firm with more than 700 attorneys in 24 offices in the United States and internationally, offers innovative solutions to the legal and business challenges presented by today's evolving global markets. The Duane Morris Institute provides training workshops for HR professionals, in-house counsel, benefits administrators and senior managers.

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