New Option for the Home Office
- Published: 03/14/2014
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Small business owners who do not have a separate business location may be able to reduce their tax liability by claiming a deduction for their qualified home office. The IRS recently created a Simplified Method for calculating the home office deduction, making recordkeeping and substantiation much easier for those claiming it. While the home office, when properly claimed, can reduce the owner’s tax bill in a number of ways, it remains one of the most poorly understood and erroneously claimed deductions on sole-proprietors’ tax returns. It is for this reason that the home office is one of the most scrutinized deductions that taxpayers claim.
In this article I will review the home office deduction and highlight the new Simplified Deduction Method. My hope is to help those who are legitimately eligible to maximize their deduction while steering clear of problems.
The Home Office Deduction: Business owners who have no other business location and use their home to manage their business may be entitled to claim the home office deduction. A home office can be a separate room or part of a room set aside for business use. To qualify as a deductible home office, the location must pass these three basic tests: 1) Be your principal place of business, 2) Be regularly used for business and, 3) Be used exclusively for business. To see if you can claim the deduction, let’s look at each test in a little more detail:
1: Principal Place of Business: Business owners who use their home office to meet with customers and clients, and owners that do not have a separate fixed location to conduct business or perform management and administrative business duties may have a home office that qualifies as their Principal Place of Business. This is particularly true of many service-related businesses that perform services at their customers’ homes and businesses and use their home office to manage and perform administrative duties such as billing, scheduling, ordering and filing, etc.
Those who own or rent a separate fixed location to conduct business, meet with customers, and perform management or administrative business duties will have a lesser chance of their home office qualifying as their primary business location. The ultimate answer, however, will depend on all of the facts and circumstances surrounding its use. These owners should consult with a tax professional to be sure.
2. Regular Business Use: To qualify as a home office, business owners must use their home office in a consistent, recurring manner. Using the office just occasionally, intermittently, or for nonrecurring special projects will probably not qualify as regular business use. Using the office an hour per day to send out invoices, schedule appointments, and order supplies, however, will qualify as regular use.
3. Exclusive Use: The final test that must be met to deduct the expenses of a home office is that the home office be used exclusively for business. Exclusive use means that the office is ONLY used for business. If the area is also used for personal use or by other family members for non-business use, the office will NOT qualify as a home office.
How to Take the Deduction: Business owners who meet the three conditions above may be able to claim the home Office Deduction for business use of their home. Thanks to a recent IRS Revenue Procedure, 2013-13, those claiming the deduction now have two options to choose from: (1) The Simplified Option and the (2) Regular Method. Qualified business owners (and certain employees not discussed in this article) can choose between the new Simplified and Regular Method year after year. Once a method is chosen, however, it cannot be changed by amending the return later that year. Regardless of the method used, if your home office was only used for part of the year, you must prorate your deduction based on the percentage of the year the office qualified for the deduction.
Overview of Regular Method: The Regular Method of calculating the home office deduction is fairly complex and requires a great deal of analysis and recordkeeping. The process is too cumbersome to share in a single article, but it basically consists of allocating all costs associated with the home office between those that are direct (related exclusively to the home office itself) and those that are indirect (shared by the entire home including the home office such as electricity and mortgage interest). Direct costs can generally be deducted in full. Indirect costs, however, must be allocated based on the proportional square footage of the home office relative to the size of the entire home. Certain indirect costs that can also be itemized such as property tax and mortgage interest must be adjusted on Schedule A if the taxpayer itemizes deductions.
Under the Regular Method, the home office itself must be depreciated. This requires additional calculations and the potential of having a taxable gain if and when the home is ultimately sold.
Finally, those using the Regular Method must keep all records to calculate their deduction and be able to prove it was correct years later should the IRS inquire about it.
The New Simplified Method: The Simplified Method alleviates many of the challenges posed by the Regular Method and is available to taxpayers beginning in 2013. The Simplified Method allows a standard deduction amount of $5.00 per square foot, up to 300 square feet, for a maximum home office deduction of $1,500.
Benefits of Simplified Method: The Simplified Method reduces the complicated calculations and eases the record-keeping burden required by the Regular Method, discussed earlier. It allows the business owner to deduct 100% of mortgage interest and real estate property taxes as an itemized deduction on Schedule A, unlike the regular method which requires additional calculations. Business owners who use the Simplified Method are also not required to depreciate the home office portion of their home as required by the Regular Method, reducing the potential capital gain tax that could occur when the home is sold.
Drawbacks of Simplified Method: The simplified does have a few drawbacks. Like the Regular Method, the home office deduction is limited to the business’ gross income less business expenses not related to the home office. Basically this means that the home office deduction cannot generate a loss. However, unlike the Regular Method, nondeductible expenses created by this limitation cannot be carried forward to be used in a later year when the business has the income to deduct them.
The Take Away: For many small business owners the home office generates a relatively small deduction which the calculation, substantiation, and red-flag risk make it difficult to justify. For others, however, a legitimately qualifying home office may allow business owners to substantially increase other deductions, such as business related auto mileage. Each business owner must honestly consider whether their home office qualifies as their regular, exclusive and principal place of business. If the office qualifies, the Regular Method remains available for those whose recordkeeping and circumstances make it advantageous. For others, including many tax professionals, the Simplified Method, is a welcome change to what has traditionally been a complex, misunderstood, and – therefore - potentially dangerous deduction.
Please remember: This or any article does not constitute or replace the advice of a qualified professional. If you would like assistance with your business or any taxes issue, please feel free to call our office at (304) 267-2594.