August 18, 2016: Home Office Deduction
The home office deduction is available to eligible business owners and employees. To be eligible for the deduction, business owners and employees need to satisfy all of the requirements of U.S. Code Section § 280A(c). In addition, business use of the home office must be for the convenience of the employer to make employees eligible. All of the facts and circumstances need to be considered when making a determination of eligibility.
The home office deduction is limited to the gross income derived from the qualified business use of the home reduced by the deductible business expenses unrelated to the qualified use of the home (for example, office supplies). Disallowed home office expenses (those that exceed the gross income limitation) can be carried over to the next succeeding tax and can be deducted, subject to the same limitations.
U.S. Code Section § 280A(c) allows taxpayer’s to deduct costs associated with a home office provided that:
The home office deduction is available to eligible business owners and employees. To be eligible for the deduction, business owners and employees need to satisfy all of the requirements of U.S. Code Section § 280A(c). In addition, business use of the home office must be for the convenience of the employer to make employees eligible. All of the facts and circumstances need to be considered when making a determination of eligibility.
The home office deduction is limited to the gross income derived from the qualified business use of the home reduced by the deductible business expenses unrelated to the qualified use of the home (for example, office supplies). Disallowed home office expenses (those that exceed the gross income limitation) can be carried over to the next succeeding tax and can be deducted, subject to the same limitations.
U.S. Code Section § 280A(c) allows taxpayer’s to deduct costs associated with a home office provided that:
- The costs are allocable to a portion of the dwelling unit which is exclusively used on a regular basis.
- The home office is used as the principal place of business for any trade or business of the taxpayer.
EXCLUSIVE TEST: To qualify under the exclusive use test, you must use a specific area of your home only for your trade or business. The area used for business can be a room or other separately identifiable space. The space does not need to be marked off by a permanent partition. You do not meet the requirements of the exclusive use test if you use the area in question both for business and for personal purposes. You do not have to meet the exclusive use test if: (1) You use part of your home for the storage of business inventory or product samples, or (2) You use part of your home as a daycare facility.
If you use part of your home for storage of inventory or product samples, you can deduct expenses for the business use of your home without meeting the exclusive use test. However, you must meet all the following tests:
REGULAR TEST: To qualify under the regular use test, you must use a specific area of your home for business on a regular basis. Incidental or occasional business use is not regular use. You must consider all facts and circumstances in determining whether your use is on a regular basis.
PRINCIPAL PLACE OF BUSINESS TEST: You can have more than one business location, including your home, for a single trade or business. To qualify to deduct the expenses for the business use of your home under the principal place of business test, your home must be your principal place of business for that trade or business. To determine whether your home is your principal place of business, you must consider: (1) The relative importance of the activities performed at each place where you conduct business, and (2) The amount of time spent at each place where you conduct business.
Your home office will qualify as your principal place of business if you meet the following requirements.
TRADE OR BUSINESS USE TEST: To qualify under the trade or business use test, you must use part of your home in connection with a trade or business. If you use your home for a profit-seeking activity that is not a trade or business, you cannot take a deduction for its business use.
EMPLOYER CONVIENENCE TEST: An employee’s home office is deemed to be for an employer’s convenience only if it is: (1) a condition of employment, (2) necessary for the employer’s business to properly function, or (3) needed to allow the employee to properly perform his or her duties. The convenience of employer test is not met if using a home office is for your convenience or because you can get more work done at home.
ACCEPTABLE METHODS OF CALCULATION: There are two acceptable methods of calculating the home office deduction: (1) allocation of actual expenses, and (2) the safe harbor method.
Allocation of actual expenses: The actual costs of the dwelling are allocated to the home office both directly and indirectly on a square footage basis.
Subsequent sale of the residence: Home office depreciation deductions have a direct impact on the tax consequences from the sale of a personal residence. The portion of the home claimed as a home office is not considered part of the principal residence but, instead, is considered business property. If the taxpayer’s residence is sold at a gain, part of the gain must be allocated to the home office. The business portion of the gain likely will be relatively larger because of home office depreciation deductions. The gain allocation issue is particularly important now that the new law provides for a $250,000 exclusion of gain ($500,000 if married and filing jointly) relating to the personal (nonbusiness) portion of the residence. Unfortunately, the new gain exclusion rules do not apply to the business portion of the gain associated with the home office.
This means that in some circumstances the home office deduction may lead to gain recognition in excess of the depreciation deduction or even the entire cumulative home office deduction itself. If the home office is converted back to personal use before the year of the sale, depreciation may still be “recaptured” as taxable income on the sale of the residence for a gain. Gains on the sale of a personal residence are required to be recognized to the extent of depreciation taken on the home office after May 6, 1997 under Section § 121(d)(6). Losses on the sale of a residence generally are not deductible. However, the portion of the loss associated with the home office will be deductible as an ordinary business loss. Once again, depreciation reduces the home office adjusted basis on the portion of the home identified as business property.
Safe harbor method: The IRS and Treasury Department recognized that the calculation, allocation, and substantiation of allowable deductions attributable to the use of a portion of the taxpayer’s residence for business purposes can be complex and burdensome for small business owners. Accordingly, they have provided, in Rev. Proc. 2013-13, an optional safe harbor method to reduce the administrative, recordkeeping, and compliance burdens of determining the allowable deduction for certain business use of a residence under § 280A. Under this safe harbor method, taxpayers determine their allowable deduction for business use of a residence by multiplying a prescribed rate by the square footage of the taxpayer’s residence that is used for business purposes.
If you use part of your home for storage of inventory or product samples, you can deduct expenses for the business use of your home without meeting the exclusive use test. However, you must meet all the following tests:
- You sell products at wholesale or retail as your trade or business.
- You keep the inventory or product samples in your home for use in your trade or business.
- Your home is the only fixed location of your trade or business.
- You use the storage space on a regular basis.
- The space you use is a separately identifiable space suitable for storage.
REGULAR TEST: To qualify under the regular use test, you must use a specific area of your home for business on a regular basis. Incidental or occasional business use is not regular use. You must consider all facts and circumstances in determining whether your use is on a regular basis.
PRINCIPAL PLACE OF BUSINESS TEST: You can have more than one business location, including your home, for a single trade or business. To qualify to deduct the expenses for the business use of your home under the principal place of business test, your home must be your principal place of business for that trade or business. To determine whether your home is your principal place of business, you must consider: (1) The relative importance of the activities performed at each place where you conduct business, and (2) The amount of time spent at each place where you conduct business.
Your home office will qualify as your principal place of business if you meet the following requirements.
- You use it exclusively and regularly for administrative or management activities of your trade or business.
- You have no other fixed location where you conduct substantial administrative or management activities of your trade or business.
- There are many activities that are administrative or managerial in nature. The following are a few examples:
- Billing customers, clients, or patients.
- Keeping books and records.
- Ordering supplies.
- Setting up appointments.
- Forwarding orders or writing reports.
TRADE OR BUSINESS USE TEST: To qualify under the trade or business use test, you must use part of your home in connection with a trade or business. If you use your home for a profit-seeking activity that is not a trade or business, you cannot take a deduction for its business use.
EMPLOYER CONVIENENCE TEST: An employee’s home office is deemed to be for an employer’s convenience only if it is: (1) a condition of employment, (2) necessary for the employer’s business to properly function, or (3) needed to allow the employee to properly perform his or her duties. The convenience of employer test is not met if using a home office is for your convenience or because you can get more work done at home.
ACCEPTABLE METHODS OF CALCULATION: There are two acceptable methods of calculating the home office deduction: (1) allocation of actual expenses, and (2) the safe harbor method.
Allocation of actual expenses: The actual costs of the dwelling are allocated to the home office both directly and indirectly on a square footage basis.
- Direct costs are expenses that relate only to the home office. These costs are 100% allocated to the home office and are fully deductible. Examples of direct costs include painting, repairs and improvements that relate only to the home office space.
- Indirect costs are allocated on a square footage basis and include insurance, utilities, general repairs, security system costs, rent (if the home is rented and not owed), and depreciation. Real estate taxes, mortgage interest, and casualty losses can be included in the home office deduction, but cannot be double counted as itemized deductions elsewhere on Schedule A.
- Unrelated costs are expenses that relate only to areas of the dwelling that are not part of the home office. These costs are not deductible.
Subsequent sale of the residence: Home office depreciation deductions have a direct impact on the tax consequences from the sale of a personal residence. The portion of the home claimed as a home office is not considered part of the principal residence but, instead, is considered business property. If the taxpayer’s residence is sold at a gain, part of the gain must be allocated to the home office. The business portion of the gain likely will be relatively larger because of home office depreciation deductions. The gain allocation issue is particularly important now that the new law provides for a $250,000 exclusion of gain ($500,000 if married and filing jointly) relating to the personal (nonbusiness) portion of the residence. Unfortunately, the new gain exclusion rules do not apply to the business portion of the gain associated with the home office.
This means that in some circumstances the home office deduction may lead to gain recognition in excess of the depreciation deduction or even the entire cumulative home office deduction itself. If the home office is converted back to personal use before the year of the sale, depreciation may still be “recaptured” as taxable income on the sale of the residence for a gain. Gains on the sale of a personal residence are required to be recognized to the extent of depreciation taken on the home office after May 6, 1997 under Section § 121(d)(6). Losses on the sale of a residence generally are not deductible. However, the portion of the loss associated with the home office will be deductible as an ordinary business loss. Once again, depreciation reduces the home office adjusted basis on the portion of the home identified as business property.
Safe harbor method: The IRS and Treasury Department recognized that the calculation, allocation, and substantiation of allowable deductions attributable to the use of a portion of the taxpayer’s residence for business purposes can be complex and burdensome for small business owners. Accordingly, they have provided, in Rev. Proc. 2013-13, an optional safe harbor method to reduce the administrative, recordkeeping, and compliance burdens of determining the allowable deduction for certain business use of a residence under § 280A. Under this safe harbor method, taxpayers determine their allowable deduction for business use of a residence by multiplying a prescribed rate by the square footage of the taxpayer’s residence that is used for business purposes.
- The allowable square footage is the portion of a home used in a qualified business use of the home, but not to exceed 300 square feet.
- The prescribed rate is $5.00 is currently, but the Service and the Treasury Department may update this rate from time to time as warranted.
- A taxpayer using the safe harbor method for a taxable year cannot deduct any depreciation for the portion of the home that is used in a qualified business use of the home for that taxable year.
- A taxpayer irrevocably (no amended returns) elects, for each tax year, whether to use the safe harbor method or to calculate and substantiate actual expenses for purposes of § 280A.
- Taxpayers who itemize deductions and use the safe harbor method for a taxable year may deduct, to the extent allowed by the Code and regulations, any expense (ie: real estate taxes, mortgage interest, casualty losses) related to the home that is deductible without regard to whether there is a qualified business use of the home for that taxable year.
- The safe harbor method does not apply to an employee with a home office if the employee receives advances, allowances, or reimbursements for expenses related to the qualified business use of the employee’s home from his or her employer.
