Working at home has come a long way from the days when employers were most concerned that they would not get their money’s worth if they allowed employees to do so. Instant communication, improved internet access, and more stable virtual network connections have changed the equation for employers, who now see the ability to work at home as benefiting both sides: employers and employees.
Although estimates vary, one source says that the number of workers regularly telecommuting (more than one day a week and not including the self-employed) grew 73% between 2005 and 2011 (Latest Telecommuting Statistics, available at tinyurl.com/a7tzewp (updated Oct. 2012)). The same source asserts that if those who have jobs that are compatible with working at home and would like to do so were permitted to work at home at least half the time, annual savings would be greater than $700 billion. This includes savings of $11,000 per person a year for the typical business and savings of $2,000 to $7,000 a year for the typical telecommuter.
In contrast to employees, the number of self-employed people working from home actually decreased during the recession. As the economy recovers, however, the number of businesses in homes should also increase.
As more people telecommute from home and people who lost jobs in the recession start businesses in their homes, it is a good time to revisit the tax rules that apply when people work from their homes. The rules are complex, so it is important to fully understand them to comply and thus withstand a possible IRS challenge. The rules to qualify are different for employees than for the self-employed, as are the procedures for claiming the deduction on a tax return.
The IRS recently announced a safe-harbor method that will make it easier for taxpayers who choose the safe harbor to take the deduction, so practitioners may see an increase in clients who want to take the deduction. However, the basic qualification rules have not changed, so an understanding of them is still important.
THE STATUTORY REQUIREMENTS
A deduction is permitted for expenses associated with that portion of the dwelling unit that is exclusively used on a regular basis either (1) as the principal place of business for any trade or business of the taxpayer; (2) as a place of business that is used by patients, clients, or customers in meeting or dealing with the taxpayer in the normal course of his or her trade or business; or (3) in the case of a separate structure that is not attached to the dwelling unit, in connection with the taxpayer’s trade or business.
For purposes of (1) above, the term “principal place of business” includes a place of business that the taxpayer uses for the administrative or management activities of the taxpayer’s trade or business if there is no other fixed location for the trade or business where the taxpayer conducts the substantial administrative or management activities (Sec. 280A(c)(1), flush language).
There are also special rules for use of a portion of the home as storage space or to provide child care facilities, which are not addressed in this article.
In most cases, the office must be the principal place of business for any trade or business of the taxpayer, which has been interpreted as meaning that “expenses attributable to the use of a home office in conducting two or more separate business activities may be deductible” (Hamacher, 94 T.C. 348, 356 (1990)). However, if a person uses one home office for numerous business activities, each activity must meet the requirements under Sec. 280A, or they will all be disqualified (id.).
For the use of a home office by an employee to qualify, the use must be for the convenience of his or her employer (Sec. 280A(c)(1), flush language). Also, if the employee rents a portion of his or her home to the employer and uses the rented space to perform services as an employee for that employer, the employee cannot take a home office deduction for expenses related to that part of the employee’s home (Sec. 280A(c)(6)).
EXCLUSIVE USE ON A REGULAR BASIS
According to the IRS, to qualify for the “exclusive use” test, taxpayers must use a specific area of their home exclusively for their trade or business, but the area does not need to be set off by a permanent partition. However, it must be used for the trade or business exclusively and at all times (not just during business hours), and any use of the space for nonbusiness purposes disqualifies the area, e.g., an office that is also used as a family room will not qualify. So, for example, where an accountant’s children and guests occasionally used the bathroom and hallway adjacent to his home office (and built for the use of his clients), that portion of the house did not qualify for the home office deduction (Bulas, T.C. Memo. 2011-201).
To qualify for regular use, the specific area of the home must be used on a regular basis; occasional or incidental use will not qualify. This determination is made based on all the facts and circumstances (see Publication 587, Business Use of Your Home (Including Use by Daycare Providers)).
WORK AT HOME IS FOR THE EMPLOYER'S CONVENIENCE, NOT THE EMPLOYEE'S
Many employees who work in their homes will not qualify for the deduction because they do it for their own convenience, not their employer’s.
It is not impossible to establish that the home office is for the employer’s, not the employee’s, convenience, but it is difficult. For example, an architect could not deduct expenses for his home office when his employer did not require him to maintain the office and he had unlimited access to his employer’s downtown office (Tokh, 25 Fed. Appx. 440 (7th Cir. 2001)).
If the use of the home office is necessary to allow the employee to perform his or her duties as an employee properly, or the use of the home office is necessary for the functioning of the employer’s business, it will be considered to be for the employer’s convenience. If the employer requires the employee to maintain a home office as part of his or her job requirements, the use of the home office is also considered to be the employer's convenience. As more people work at home and are not provided a space to work at their employer’s premises, it may be easier for employees to establish that it is being done for the employer’s convenience, say, to save the employer on the cost of providing workspace in the company’s office.
However, in the absence of a specific requirement by their employer that they work at home, when the “convenience of the employer” requirement is litigated, taxpayers in the past have usually lost. Taxpayers with the right facts and circumstances can win, though, as happened in Drucker, 715 F.2d 67 (2d Cir. 1983). The taxpayers in Drucker were musicians with the Metropolitan Opera in New York City who, the court found, had their principal place of business at their home practice studios, which was “the rare situation in which an employee’s principal place of business is not that of his employer.” The court found that it was a necessity for the musicians to spend long hours practicing individually to perform their jobs, and the Met did not provide space to practice privately at its performance facilities, so that practicing at home was in fact a requirement or condition of employment for the musicians.
CALCULATING THE AMOUNT OF THE DEDUCTION
Calculating the home office deduction can be done one of two ways: the actual-expense method, under which the home office deduction amount is based on the actual expenses related to the use of the home office incurred by the taxpayer, or the new safe-harbor method, under which the deduction amount is determined by a formula based on the square footage used as a home office.
Whichever method is used to calculate the deduction, the amount of the deduction is subject to a gross income limitation, which, as discussed below, is calculated differently for each method. In addition, the carryforward rules for the deduction are different under each method. Under the actual-expense method, any excess of otherwise deductible expenses over the gross income limitation can be carried forward to the next tax year, subject to the same limitation (Sec. 280A(c)(5)). If the safe-harbor method is used, the amount of otherwise deductible expenses in excess of the limitation cannot be carried forward to future tax years.
Under the actual-expense method, taxpayers first must determine the percentage of their home that is used for business. This can be done by any reasonable method, but the most common approaches are either (1) the square-footage approach, in which the area used for business is divided by the house’s total square feet, or, (2) if the rooms in the home are all of a similar size, determining the percentage by dividing the number of rooms used for business by the total number of rooms in the house. For example, using the first method, a taxpayer whose office is 12 feet by 15 feet and whose house is 2,000 square feet uses 9% of the house in the trade or business.
After determining the percentage of the home expenses that the taxpayer can deduct as expenses for the business use of his or her home, the next step is to determine whether the deduction is subject to the gross income limitation. The deduction of otherwise nondeductible home expenses, such as insurance, utilities, and depreciation (with depreciation taken last), that are allocable to the business, is limited to the gross income from the business use of the taxpayer’s home, less:
- The business part of expenses the taxpayer could deduct even if he or she did not use the home for business (such as mortgage interest, real estate taxes, and casualty and theft losses that are allowable as itemized deductions on Schedule A, Itemized Deductions (Form 1040)); and
- The business expenses that relate to the business activity in the home (e.g., business phone, supplies, and depreciation on equipment), but not to the use of the home itself. Self-employed taxpayers cannot include their deduction for the deductible part of their self-employment tax as expenses in the second category.
The calculation of a taxpayer’s business use percentage and allowable deduction amount are performed on Form 8829, Expenses for Business Use of Your Home, for Schedule C filers, or on the “Worksheet to Figure the Deduction for Business Use of Your Home” in Publication 587 for employees and others.
THE NEW SAFE HARBOR
In January, the IRS released Rev. Proc. 2013-13, which gives taxpayers an optional safe-harbor method to calculate the amount of the deduction for expenses for business use of a residence beginning with the current tax year, 2013, for returns filed in 2014.
Individual taxpayers who elect this method can deduct an amount determined by multiplying the allowable square footage by $5. The allowable square footage is the portion of the house used in a qualified business use, but not to exceed 300 square feet. Therefore, the maximum a taxpayer can deduct annually under the safe harbor is $1,500. The IRS may update the $5 allowance from time to time, but it is not inflation adjusted. Because the up-to-$1,500 amount is a safe harbor, taxpayers who use the safe harbor cannot also deduct actual expenses related to qualified business use of the home for that year; however, business expenses that are unrelated to the use of the home (such as advertising) can be deducted.
To use the safe-harbor method, taxpayers must continue to satisfy all the other requirements for a home office deduction, including the requirement that the space in the residence used as an office be used exclusively for that purpose and the limitation that an employee qualifies for the home office deduction only if the office is for the convenience of the taxpayer’s employer. The safe harbor is elected on a timely filed original tax return, and taxpayers are allowed to change their treatment from year to year. However, the election for any tax year is irrevocable.
No depreciation is allowed for the years in which the safe harbor is elected. This may make this method more attractive for taxpayers who do not plan to stay in their homes a long time because they will then avoid the depreciation recapture that is required of taxpayers who took depreciation on their personal residences.
A taxpayer who itemizes deductions and uses the safe harbor for a tax year may deduct, to the extent allowable, any expense related to the home that is deductible without regard to whether there is a qualified business use of the home for that tax year (e.g., deductions for qualified residence interest, property taxes, and casualty losses). Taxpayers using the safe harbor deduct these expenses as itemized deductions on Form 1040, Schedule A, and cannot deduct any portion of these expenses from the gross income derived from the qualified business use of the home, either for purposes of determining the net income derived from the business or for purposes of determining the gross income limitation discussed directly below.
Like the actual-expense method, the deduction under the safe-harbor method is subject to a gross income limitation. The amount of the deduction computed using the safe-harbor method cannot exceed the gross income derived from the qualified business use of the home for the tax year reduced by the business deductions unrelated to the qualified business use of a home. Unlike the actual-expense method, however, taxpayers cannot carry over any excess to another tax year. If a taxpayer uses the actual-expense method for calculating the deduction and has had his or her deduction limited by the gross income limitation in that year, the taxpayer can deduct this amount in the next year he or she uses the actual-expense method, but cannot use the disallowed amount in a year he or she elects the safe-harbor method. This limit on carryovers for the safe-harbor method means taxpayers must be careful before electing it to be sure they will not lose any of their deduction.
Taxpayers sharing a home (for example, roommates or spouses, regardless of filing status) may use the safe-harbor method provided by the revenue procedure, but not for qualified business use of the same portion of the home.
Under the safe harbor, taxpayers who have a qualified business use of more than one home for a tax year may use the safe harbor for only one home, but they may use the actual-expense method for the other homes. If a taxpayer has more than one qualified business use of the same home, however, and uses the safe harbor, he or she must use the safe harbor for all of the business use of the home and thus will be limited to the $1,500 deduction for all of his or her businesses in the home.
The digital age means more and more people are working from home offices for employers and for themselves. Recent advances in technology enable many people to set up home offices with very little trouble, as access to high-speed internet and virtual networks from the home increases. Environmental concerns will add to employers’ and employees’ wish to permit telecommuting to expand. And, unfortunately, during the recession, the number of underemployed or unemployed people increased, and, as the economy recovers, more of them may want to start businesses in their homes. All these changes mean practitioners and taxpayers would do well to refamiliarize themselves with the rules that apply to home office deductions.
The new safe-harbor method will probably induce taxpayers to claim a home office deduction who were scared off in the past—either by the deduction’s complexity or from fear that it is an IRS audit “red flag.” Practitioners should be prepared to help those taxpayers determine which method is better in their circumstances.
In recent years the number of people working from home has increased dramatically, especially for employees.
Using a portion of their home in a trade or business can enable taxpayers to take a deduction for home office expenses.
The tax return treatment and the rules for qualifying for the deduction are different for the self-employed and employees.
The rules for calculating these expenses are complex, and as a result, many taxpayers have not wanted to risk the increased IRS scrutiny that taking the deduction might bring.
New safe-harbor rules make it easier to take the deduction, although taxpayers must still meet other requirements to qualify.
Sally P. Schreiber is a JofA senior editor. To comment on this article or to suggest an idea for another article, contact her at firstname.lastname@example.org or 919-402-4828.
“Checklist: Home Office Deduction,” Jan. 2012, page 20
- AICPA’s 2012 Annual Federal Tax Update (#731145)
- Innovative Tax Planning for Individuals and Sole Proprietors (#745536)
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