October 27, 2014
Using a portion of a home for business may qualify taxpayers for deductions on an individual tax return. Historically some taxpayers have declined the deduction either because of the record keeping burden or because of a perception that claiming the deduction increased the risk of an IRS audit. The IRS introduced a significant modification to the existing regulations in 2013. The basic qualification rules did not change, and they are complex. However, with the new simplified method, also called the safe harbor method, taxpayers should consider revisiting the deduction and determining the potential benefit.
Stringent rules on usage of the home office still apply. The space must be used exclusively and regularly as a principal place of business, as a place to meet or deal with clients and customers in the normal course of business, or “in connection with” the business if the space is a separate structure from the residence.
The regular and exclusive use tests can be hard to meet. Regular use means on a continuing basis, occasional usage will not merit the deduction. Exclusive means there is no other use of the space. The office may not be used for paying personal bills or for filing household documentation. In addition, others in the family may not use the space. There are exceptions to exclusive usage for the storage of inventory or product samples if the home is the sole, fixed location of the business, and for certain daycare facilities. In these instances, the space may be used for personal purposes without disqualifying the home office deduction.
Home office deductions are available to both self-employed taxpayers and employees. If the taxpayer is an employee, the business use of the home must be for the convenience of the employer, and the space must be used exclusively and regularly for job-related activities. If a taxpayer has an office furnished by the employer, it is difficult to pass these tests.
The choice to use the simplified option or the regular method is made on a year-by-year basis. Under the simplified, safe-harbor method, taxpayers may deduct $5 per square foot of home office space, up to a maximum of $1,500 per year. Taxpayers are not required to substantiate the expenses incurred for their home and may still deduct mortgage interest and real estate taxes in full on schedule A. Depreciation is not taken in a year the taxpayer uses the safe harbor method.
There are certain strategies that can determine whether it is best to use the simplified or the regular method. If expenses exceed gross income from the business for self-employed taxpayers, the safe harbor method is not the best choice, as the deduction is not allowed and is permanently lost. If the regular method is used, expenses will carry forward to the next tax year to offset income from the business. There is potential for the simplified method to not provide full benefit to high income taxpayers, as at higher income levels deductions for mortgage interest and real estate tax on schedule A are limited. With the regular method a portion of these expenses can still be taken without limitation for the home office.
If it is determined that the business use of part of your home is a qualified home office, a further benefit may be realized in the form of a deduction for business miles driven. Typically miles driven from home to a place of business is considered commuting and is a personal expense. However, once the criteria for the home office is established, generally 100% of miles driven for business become deductible, since there are no commuting miles to consider.
While the rules are complex, a competent CPA can assess your situation to determine if you qualify for the deduction and the best method to use.
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