Small Business Taxes & ManagementTM--Copyright 2013, A/N Group, Inc.
Income limitation. Your home office deduction is limited to the amount of income from the activity. For example, Fred's Schedule C, before the home office deduction, shows only $200 of income. His home office expenses from Form 8829 total $1750. His home office deduction is limited. While he can take the casualty losses, mortgage interest, and real estate taxes in full, his other expenses such as utilities, insurance, etc. and depreciation, will be limited to his income from the business. Any unused expenses can be carried forward and used in subsequent years, subject to the income limitation.
Sales of business property are reported separately on Form 4797 (Sales of Business Property). Any gain should be added to the income from the business for use in computing the income limitation.
You can use the home office for more than one business, but you'll have to file a separate Form 8829 for each business. You could run into an income limitation on one business and not the other.
Sale of the home. You're allowed to exclude up to $250,000 ($500,000 if married filing joint) of gain on the sale of your home, but only if you've owned and used the home as your principal residence for at least two out of the last five years, ending on the date of sale. If the property was used partly as a home and partly for business, and the home office isn't a separate structure, you don't have to allocate gain on the sale between the business party and the home part. However, you can't exclude any part of the gain equal to any depreciation allowed or allowable after May 6, 1997, even if you qualify for a gain exclusion. The depreciation recapture (unrecaptured Sec. 1250 gain) is taxed as ordinary income, but no more than 25%.
The rule is different if you used a separate structure, such as an outbuilding or barn, for business. You cannot exclude gain on the separate part of the property used for business unless you owned and lived in that part for at least 2 years during the 5-year period ending on the date of sale. If you don't meet this use test, an allocation of the gain on the sale must be made. You'll have to report gain on the sale as well as any depreciation recapture (see above).
If the business use was in a separate structure and you met the use test but used he property for business in the year of sale (e.g., in 2011 and 2012 you used the property for personal purposes but in 2013, the year of sale, you used it for business), you still have to do an allocation and report the sale of the gain on Form 4797, but you can allocate a portion of your $250,000/$500,000 exclusion to the gain on the property. If you used the property for personal purposes in two of the last five and there was no business use in the year of sale, you don't have to file Form 4797.
Seasonal use. You may have to allocate the home office use if you have a seasonal business and don't use the space during a part of the year. For example, you employ several neighbors to help you package and ship gifts during the Christmas season and use your garage for three months. During the rest of the year none of the space is used for business and is used solely for personal purposes.
Employees and Partners. The rules for deducting expenses by employees or partners are different. First, the home office expenses for employees will be deductible on line 21 of Schedule A of Form 1040. You won't need Form 8829, but you will need a worksheet that looks very similar. You'll apportion your expenses just as you would on Form 8829, but your mortgage interest and real estate taxes will only be used to determine the limitation for your home office deduction. You can deduct the full amount of your interest on line 10 or 11, and your real estate taxes on line 6.
In most cases your home office expenses will be first reported on Form 2106, most likely along with other unreimbursed business expenses. The total from Form 2106 will be carried to Schedule A, line 21 as a miscellaneous itemized deduction, subject to the 2% floor. While it sounds complicated, if you use computer software the mechanics will be easy.
For partners in a partnership (or LLCs filing as a partnerhip) report any unreimbured partnership expenses on a separate line on Schedule E of Form 1040. You can only deduct amounts here if you were required to pay the expenes under the partnership agreement (except amounts deductible only as itemized deductions, which you must enter on Schedule A).
Safe Harbor Rule
If recordkeeping and completing Form 8829 sounds like too much trouble there is another option. Rev. Proc. 2013-13 provides a safe harbor method (also known as the simplified method) that allows you to simply multiply the square footage for your home office by $5.00 a square foot. The maximum amount of space that qualifies for the safe harbor is 300 square feet. Thus, your deduction for any year is limited to $1,500. While that may not sound like much, your deduction using the actual expenses may not be that much more. We'll discuss this in more detail below. The safe harbor applies to both employees who maintain a home office and self-employed individuals. While the $5 rate is not indexed for inflation, the IRS has indicated it could update the amount from time-to-time.
Recordkeeping and audit potential. The big advantage of using the safe harbor rule is that you don't have to worry about keeping records of the home expenses. That may or may not be an issue for you. But, if you're audited, the IRS may look at not only whether you incurred the expense but whether or not it was deductible.
And that's where the safe harbor has an audit advantage. If the IRS questions your home office deduction they will be looking at whether you qualify for the deduction and the amount taken. If you're using the safe harbor, they can only argue the first point. That may reduce the incentive to audit the deduction.
Qualifying. Keep in mind that the safe harbor only applies to the deductible expenses. The rules for qualifying for a home office deduction are unchanged for both employees and self-employed individuals.
Alternative to actual expenses of home office. Once you elect the safe harbor method you can't deduct any actual expenses related to the qualified business use of the home for that taxable year. That could be an issue if you have a separate heater for the space and you use a subantial amount of energy or there's some other direct expense associated with the business use of the space.
Other business expenses allowed. The safe harbor method has no effect on the deduction of other business expenses. For example, you have a machine shop in your garage with a hoist for heavy items. The hoist is not part of the garage and is depreciated separately. The same is true for shelving that's not permanently attached, workbenches, etc.
Reimbursements. 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 business use of the emploee's home under a reimbursement or other expense allowance arrangement with his or her employer.
Year-by-year election. You may elect the use of the safe harbor method on a year-by-year basis. That is, you can use the safe harbor method in 2013 and then elect to use actual expenses in 2014 and then switch back to the safe harbor in 2015. You elect the safe harbor method by using the method to compute the deduction for the qualified business use of the home on a timely filed, original federal income tax return. An election for any year, once made, is irrevocable.
Otherwise allowable home deductions. One of the advantages of taking the safe harbor deduction is that you can deduct your qualified residence real estate taxes and mortgage interest (and casualty losses) in full. Special rules apply if you rent a portion of your home as well as take a home office deduction.
Income limitation. As with the actual expenses method, there's an income limitation if you use the safe harbor method. The home office deduction is limited to the net income before the home office deduction, that is, the gross income from the business less deductions. Thus, the deduction can bring your Schedule C income down to zero, but not below.
If you use the actual expense method you can carry forward any unused amount to subsequent years. That's not the case with the safe harbor method. Any amount not used for the year is lost.
If you use the actual expense method for one year and there is an unused amount it can be carried to subsequent years to be used, subject to the same limitation. However, the carried forward amount cannot be used in a year you elect to use the safe harbor method. Instead, the carryforward amount can continue to be carried forward to a year when the actual expense method is used. For example, in 2012 you used the actual expense method and could not use $1,400 of the expense. In 2013 you elect the safe harbor method so you can't use the $1,400 carryforward. However, in 2015 you once again use the actual expense method. You can use the $1,400 as part of your home office expense.
Partial months. For determining the allowable square footage if you have a seasonal busines or a business that begins during the taxpayer year, or you change the square footage of the qualified business use (either by increasing or decreasing) you must determine the average of the monthly allowable square footage for the taxpayer year. In determining the average monthly allowable square footage, no more than 300 square feet may be taken into account for any one month, and you're treated as using the space for a month only if you used it more than 15 days in that month.
Other points. If you and your spouse (or anyone else) sharing a home can each use the safe harbor method, but not for a qualified business use of the same portion of the home. For example, Fred has a profitable fly-tying business he operates out of a spare bedroom. His wife, Sue, operates her accounting practice out of another spare bedroom. Each can use the simplified method for up to 300 square feet.
Choosing the best method, actual expeneses or the safe harbor, without tax software would be extremely time consuming. There's just too much interaction. For example, if you're using the actual expense method you'll be deducting some of your real estate taxes and mortgage interest as a business expense. Assuming you're self-employed, that will reduce your self-employment income which will result in lower income taxes and self-employment taxes. At the same time you'll have less of a deduction on Schedule A which will offsetting. Of course, that assumes you're itemizing. And you'll get a deduction for the half of your self-employment tax when computing your taxable income. Once your self-employment income is above the threshold ($117,000 in 2014) you won't be responsible for the Social Security portion of that tax. There are other, less important, factors to consider such as the phaseout of itemized deductions for high income taxpayers and the alternative minimum tax, but those are the important ones.
Of course, the value of the deduction will depend heavily on your tax bracket. The same home office expense of, say $2,500, will save you only $250 if you're in the 10% bracket but $990 if you're in the 39.6% bracket.
The amount of your deduction will depend on your mortgage interest, real estate taxes, utilities and the cost and fair market value of your home as well as percentage of the home used for business. The best way to get a feel for the value of the dollars involved is by several examples. See below.
If you clearly qualify for, but haven't taken the home office deduction in the past, spending time with the numbers makes sense if:
You might want to consider the safe harbor method if your mortgage interest, real estate taxes and cost basis of your home are low.
We've tried to make these examples as realistic as possible. Clearly, items such as real estate taxes vary widely. Taxes on a house in a metropolitan suburb could be $8,000; the identical home in the rural midwest could be a fraction of that. Much the same is true for mortgage interest and the value of the home.
Example 1--Fred and Sue file married. Fred is retired but Sue works as an consulting engineer. Before a home office deduction, her Schedule C profit is $75,000. They're in the 15% bracket. Sue uses 100 square feet in a 1,500 square foot house. Their mortgage interest is $17,000; real estate taxes $6,000; insurance $1,200; repairs $1,500; and utilities $2,500. They have no direct expenses. The value of the house (excluding the land) is $250,000.This is why you've got to work through the numbers. Everyone has a different threshold. You may consider the $283 savings using the actual over the safe harbor method in example 1 not worth the work of putting together your home expenses and the extra $50 your accountant may charge. Your neighbor may consider a $40 saving worth the extra effort.
Using these assumptions their income (and self-employment) tax (2013) would be $13,127. If they decided not to claim a home office deduction their tax would be $13,786 ($659 more). If Sue used the simplified method, their tax would be $13,410. Using the actual expense method produces only $283 in tax savings over the safe harbor method.
Example 2--The facts are the same as in the example above, but Sue uses 300 square feet for office and workshop. Their mortgage interest is $30,000; real estate taxes are $12,000; and the price of the home excluding land is $550,000.
Using the actual expense method results in income (and S-E) tax of $9,024 vs. $11,939 if they didn't claim the home office. That's a savings of $2,915. Using the simplified (safe harbor) method results in taxes of $10,571. So here the actual method produces tax savings of $1,368 over the safe harbor method.
Example 3--The facts are the same as in example 2, but Fred's trust fund income puts them in the 39.6% bracket. The home office deduction saves them $6,812 under the actual expense method and $4,160 using the simplified method. At first glance that doesn't make sense. The safe harbor method only provides a $1,500 deduction; the actual method a deduction of $12,260. But under the actual expense method Fred and Sue can't deduct $2,400 in real estate taxes and $6,000 in mortgage interest (before phaseouts).
Copyright 2013 by A/N Group, Inc. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is distributed with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional should be sought. Articles in this publication are not intended to be used, and cannot be used, for the purpose of avoiding accuracy-related penalties that may be imposed on a taxpayer. The information is not necessarily a complete summary of all materials on the subject. Copyright is not claimed on material from U.S. Government sources.--ISSN 1089-1536
--Last Update 12/16/13