“Safe harbor” option may be easier, but number crunching is still worth it for many
The IRS simplified option for home office deductions five years ago and million or taxpayers are taking advantage. Just be careful if you do.
This option can significantly reduce paperwork.
However, the annual limit is $1,500, and those with higher home office expenses may still be better off slogging through the detailed Form 8829.
According to the IRS, more than 3.4 million taxpayers claimed deductions totaling just over $9.6 billion for business use of a home, commonly referred to as the “home office deduction.”
Introduced in tax year 2013, the optional deduction is designed to reduce the paperwork and recordkeeping burden for small businesses. The optional deduction is capped at $1,500 per year, based on $5 a square foot for up to 300 square feet.
Back in 2013, the IRS announced a new, simplified method for claiming home office deductions. According to the IRS, this safe harbor method is an alternative to the existing requirement of calculation, allocation and substantiation of actual expenses, including mortgage payments and depreciation that is done in Form 8829.
Moreover, there is an annual limitation of $1,500 under this new method, thus making this a viable option for those with offices in apartments or smaller homes. Still, there is merit to understanding this option now and evaluating the best course for your business deductions.
Which method is best for me?
Before we look at the new option, let’s run through the existing method. The existing method involves several steps before you can arrive at the total for a home office deduction.
Step 1: Figure the percentage of your home used for business
Divide the total square footage of your home that you use for business by the square footage of your entire house. That percentage is what you’ll need for Step 3 below.
Step 2: Sum up all the expenses
This step involves the most paperwork. You need to list the various expenses such as rent and utilities or—in the case of ownership—mortgage interest, real estate taxes, insurance, repairs, utilities and the big one—depreciation. Lines 36 to 41 on Form 8829 involve going back and forth between the instructions several times to arrive at appropriate depreciation numbers.
Step 3: Apply the percentage from Step 1 to Step 2
You will use the percentage from Step 1 to figure the business part of the expenses for operating your entire home.
Now the new safe harbor option lets you claim a flat deduction of $5 per square foot of the home office, up to 300 square feet. That means if you use this method and have a home office of more than 300 square feet, you will be able to claim a maximum deduction of $1,500.
Some of the benefits of this method are:
You drastically reduce paperwork and compliance burden.
If you itemize deductions and use the safe harbor method, those expenses related to your home, such as mortgage interest and real estate taxes, can be itemized without allocating them between personal and business expenses.
You can choose either method from year to year depending on which one is beneficial in a particular year. A change from using the safe harbor method in one year to actual expenses in a succeeding taxable year or vice versa is not a change in your method of accounting and does not require the consent of the IRS.
Some of the limitations of this method are:
You are limited to claiming $1,500 per year irrespective of actual expenses incurred on the home office.
If you have a loss and cannot claim the entire deduction of $1,500 in a year, you cannot carry forward the home office expense to the following year. This would be possible if you claim actual expenses. Moreover, if you choose the safe harbor method, you cannot set off office expense carried forward from an earlier year.
The definition of what qualifies as a home office has not changed. In short, the home office
Must be used as your principal place of business.
It must be used “regularly and exclusively” for business
It cannot double as a place that you use for business as well as for personal purposes.
If you’re a professional, you may face various scenarios. You might be working from home for the most part of your practice, or you might be working from an office location but sometimes doing work at home. Each scenario is dealt with differently from a home office deduction point of view.
Home as your principal place of business: If you work from home for the most part of your business or practice, that is, you perform all important activities at this place and spend relatively more time there, then your home would be your principal place of business. In such a case, you can claim a deduction for the portion of your home that you use regularly and exclusively for your business.
Business at office location while doing some work at home: If you have separate office premises for conducting your business, then that would be your principal place of business. You cannot claim a deduction for use of your home during weekends or after office hours.
However, there is an important exception for professionals who also use their home for client meetings.
If you meet or deal with clients or customers in your home in the normal course of your business, even though you also carry on business at another location, you can deduct your expenses for the part of your home used exclusively and regularly for business if you meet both of these tests:
You physically meet with patients, clients or customers on your premises.
Their use of your home is substantial and integral to the conduct of your business.
The part of your home that you use exclusively and regularly to meet clients or customers does not have to be your principal place of business. Using your home for occasional meetings and telephone calls will not qualify you to deduct expenses for the business use of your home.
You and your tax advisor can make a decision regarding which method to choose, depending on a few pointers:
Do a back-of-the-envelope calculation of your home office expenses under both methods. Calculate the deduction under the safe harbor method by multiplying the area of your home office by $5 (limited to $1,500). If that is significantly less than the amount you claimed as a deduction in your most recent tax return, it might make sense to go through the trouble of filling out Form 8829.
If you have a loss from your business and would like to carry forward the home office expense, choose the actual expense method. If you have home office expenses from an earlier year that you would like to set off, use the actual expense method.
Claiming home office deductions is widely believed to be a common cause for an IRS audit. At the same time, genuine use of your home for business purposes can hand you a valuable deduction. The new method can significantly reduce paperwork and compliance burden for those with small home offices. But those with bigger spaces may want to choose the actual expense method. Cumbersome as it may seem, it might well be worth the effort.
DISCLAIMER: The views expressed in this article do not necessarily express the views of our firm and should not be construed as professional tax advice.
Robert J. Pyle, CFP®, CFA is president of Diversified Asset Management, Inc. (DAMI). DAMI is licensed as an investment adviser with the State of Colorado Division of Securities, and its investment advisory representatives are licensed by the State of Colorado. DAMI will only transact business in other states to the extent DAMI has made the requisite notice filings or obtained the necessary licensing in such state. No follow up or individualized responses to persons in other jurisdictions that involve either rendering or attempting to render personalized investment advice for compensation will be made absent compliance with applicable legal requirements, or an applicable exemption or exclusion. It does not constitute investment or tax advice. To contact Robert, call 303-440-2906 or e-mail firstname.lastname@example.org.
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