With a home office, taxpayers claim a business deduction for expenses arising in a qualifying use of all or part of a residence. However, taxpayers often are uncertain about the finer points of the requirements for a home office and may be unaware of all the types of business arrangements in which they can claim a deduction, such as by owners of a partnership interest.
For a taxpayer to be eligible for a home office deduction, the dwelling unit must be one of the following:
- The principal place of business;
- A place to meet patients, clients, or customers in the normal course of business;
- A separate structure not attached to the dwelling and used in connection with the business; or
- If the dwelling is the only fixed location of the taxpayer's business, a space within it that is used regularly to store the business's inventory or product samples (Secs. 280A(c)(1)(A) through (C) and 280A(c)(2)).
Note, however, that unreimbursed expenses attributable to the trade or business of being an employee, including those of maintaining a home office, are no longer deductible as a miscellaneous itemized deduction due to the suspension of such deductions by Sec. 67(g), for tax years 2018 through 2025, as added by the legislation known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97. This means that employees who work from home are no longer entitled to claim an itemized deduction for home office expenses, even if the employer requires the employee to maintain a home office. If clients have lost this valuable tax break, they also may wish to encourage their employer to set up an accountable plan (see "Start or Review an Accountable Plan," JofA, Feb. 2020).
EXCLUSIVE AND REGULAR USE
In all cases, a home office must be used regularly and exclusively to conduct business. Spreading work out on the kitchen table does not qualify, even if it happens every day, because the area is not exclusively used for work. A completely isolated workspace is not necessary. The IRS allows for a "separately identifiable space"; in other words, partitions are not required (IRS Publication 587, Business Use of Your Home, p. 3 (2019)). A desk in a corner of a room could qualify if it is used exclusively for work. However, the IRS is strict in its interpretation of "exclusive use" of the space. Even children's toys or a television in the "exclusive use" zone is enough to disqualify the space (but for special rules pertaining to day care services, see Prop. Regs. Sec. 1.280A-2(f)).
The taxpayer must also regularly use the area of the home for business. Incidental or occasional use of an area is not regular use, and expenses related to such use are not deductible, even if the space has no other purpose. Exclusive use is not required if a residence is used as a day care facility or for storage of inventory or product samples when there is no other business location.
PRINCIPAL PLACE OF BUSINESS
"Principal place of business" is determined by facts and circumstances. To assess where the principal place of business is, if a taxpayer has multiple work locations, consider the relative importance of the activities conducted in each location, the amount of time spent there, and whether another fixed location might compete as the principal place where work is done (Rev. Rul. 94-24; Prop. Regs. Sec. 1.280A-2(b)). Be sure to confirm basic facts, such as where sales, personal property, and payroll taxes are paid.
A home office can meet the principal-place-of-business test even if the taxpayer doesn't spend most of his or her working day there, provided it is the only place used for administrative and management activities. For instance, a plumber earns most of his or her revenue on job sites but still can have a home office where client scheduling, bookkeeping, and business oversight occur (Publication 587, p. 4, Example 1). The key to supporting a home office deduction is to show that it is the nerve center of the business, not just a convenience. (A side benefit of qualifying a home as the principal place of business is the ability to treat travel between the home and work locations as a deductible business expense.)
A PLACE TO MEET PATIENTS, CLIENTS, OR CUSTOMERS
Using part of a home as a place to meet clients allows more flexibility, and it can be deducted even if there is another principal place of business. For example, if a self-employed attorney meets clients at home two days a week but works out of another office the other three days, the home office qualifies for a deduction (Publication 587, p. 6). Use of the home to meet with patients, clients, or customers must be "substantial and integral" to the business (Prop. Regs. Sec. 1.280A-2(c)). Videoconferencing or occasional meetings are likely not enough.
A SEPARATE STRUCTURE
Deducting expenses related to a structure that is not attached but is "accessory or incident to" the home itself is the easiest standard to meet. For example, qualifying expenses of an artist's studio in a building near the home are deductible (S. Rep't No. 94-938, 94th Cong., 2d Sess., p. 148 (1976)). It is better from an expense deduction standpoint if the structure is not "appurtenant" to a home, but generally, a separate structure will be considered appurtenant and the home office restrictions will apply if it is located near the dwelling and expenses are shared for both the office and the house (Scott, 84 T.C. 683 (1985)).
CALCULATING THE DEDUCTION: ACTUAL-EXPENSE METHOD
The home office deduction is computed by categorizing the direct vs. indirect business expenses of operating the home and allocating them on Form 8829, Expenses for Business Use of Your Home. Direct expenses can be fully deducted. For instance, the costs of carpeting and painting the home office room are 100% deductible. Indirect expenses are allocated pro rata between business and personal use. Any reasonable method can be used. Ratios based on square footage are most common, but the number of rooms used for business vs. personal use has been allowed as well (Prop. Regs. Sec. 1.280A-2(i)(3)). Indirect expenses include real estate taxes, mortgage interest, rent, utilities, insurance, depreciation, maintenance, and repairs.
The Sec. 164(b)(6) limitation on the deduction of state and local taxes introduced by the TCJA does not affect the amount of real estate taxes that can be deducted as part of home office expenses. As was the case before passage of the TCJA, the business use portion of the tax is calculated by multiplying the full amount of the real estate taxes by the business use percentage, and the business use portion is deductible under Sec. 280A(c). The individual portion of the real estate taxes is combined with the taxpayer's other state and local taxes to determine whether the taxpayer's individual deduction for state and local taxes is limited to $10,000. The business portion of the real estate taxes is deductible whether the taxpayer itemizes or takes the standard deduction.
Not all indirect expenses may be included in the allocation. For instance, utilities and services not used in the business, lawn care, and the first telephone line to the house all must be excluded. An example of an excluded utility would be propane gas supplied for cooking on the kitchen range.
GROSS INCOME LIMITATION, ORDERING, AND CARRYOVER
Deductions for home office expenses are limited to the gross income generated by that business. Deductions that are limited can be carried over to the next year, where they will be subject to the same income tests. It is possible that carryover home office expenses will never be deducted if the expenses of the business continue to exceed the income. Prop. Regs. Sec. 1.280A-2(i)(5) requires that allocated indirect expenses be allowable in a specific order:
- Tier 1: Mortgage interest and real estate taxes;
- Tier 2: Allocated expenses that would otherwise be deductible business expenses, such as repairs, maintenance, utilities, and insurance; and
- Tier 3: Depreciation.
Rev. Proc. 2013-13 provides a safe harbor that allows taxpayers to avoid the recordkeeping and complex calculations required by the actual-expense method. Taxpayers may use the prescribed rate of $5 per square foot of the portion of the home used for business, up to a maximum of 300 square feet. Under the safe-harbor method, no depreciation is deducted, and qualified residence interest, property taxes, and casualty losses are deductible on Schedule A, Itemized Deductions. There is no carryover provision under the simplified method.
A taxpayer elects to use the simplified method simply by using it on a timely filed tax return. Once the election is made, it is irrevocable for that year. However, a taxpayer can alternate methods from year to year. The choice is not considered an accounting method change, and no special statement is necessary if the election changes from one year to the next. There are some additional considerations:
- A taxpayer who has qualified business use of more than one home in the same year can use the simplified method for only one of the homes (Rev. Proc. 2013-13, §4.08(7)).
- No disallowed amounts from the previous year can be deducted.
- If the taxpayer uses the simplified method and then switches back to actual expenses, depreciation must be calculated using the appropriate optional depreciation table for the modified accelerated cost recovery system (MACRS) applicable for the property (found in IRS Publication 946, How to Depreciate Property), regardless of whether the taxpayer used an optional depreciation table for the property in its placed-in-service year. Additionally, while electing the simplified method has no effect on the depreciable basis of the home office, the year that the simplified method is used is counted for purposes of the MACRS recovery period (Publication 587, p. 8, and Rev. Proc. 2013-13, §4.09).
PARTNER'S HOME OFFICE DEDUCTION
Owners of partnership interests can also deduct home office expenses on their individual Form 1040, U.S. Individual Income Tax Return. If the expense is of the type the partner is expected to pay without reimbursement, the partner can deduct the expense on Schedule E, Supplemental Income and Loss, as "unreimbursed partner expense" (UPE). Per Schedule E instructions, UPE should be reported on a separate line of the section reporting partnership loss, along with the name of the partnership, a description of the amount, and the notation "UPE." Form 8829 can be used to determine the appropriate deduction, but the form itself does not need to be filed.
The IRS takes the position that partnership expenses are not deductible on an individual return unless the partnership agreement expressly states that the partner is required to pay the expense personally (McLauchlan, 558 Fed. Appx. 374 (5th Cir. 2014); see also Technical Advice Memos 9316003 and 9330004). Take care to ensure that the partnership agreement includes language that each partner or member is required to pay for home office and other partnership expenses without reimbursement. Of course, the taxpayer should also have adequate substantiation of the expenses.
Unlike the sole proprietor's home office deduction, UPE can be deducted if it exceeds the income reported through the Schedule K-1, Partner's Share of Income, Deductions, Credits, etc. (subject to basis limitations). UPE is deductible against both federal income tax and self-employment tax.
S CORPORATION OWNERS AND OTHER EMPLOYEES
Unreimbursed corporate expenses paid by shareholders are treated as unreimbursed "employee" business expenses. As noted earlier, under the TCJA, unreimbursed employee business expense deductions are no longer permitted. Like other employers, S corporation owners should establish an accountable plan to have the company reimburse home office allocations.
About the author
Dayna E. Roane, CPA/ABV, CGMA, is a shareholder with Perry & Roane PC in Niwot, Colo.
To comment on this article or to suggest an idea for another article, contact Paul Bonner, a JofA senior editor, at Paul.Bonner@aicpa-cima.com or 919-402-4434.
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