The IRS Home Office deduction-do you qualify, pros and cons of taking it?
So as we are now approaching almost a full year since the Coronavirus pandemic first hit the United States. Soon after in March 2020 resulted in shutting down many offices and businesses which started this remote work-from-home trend that may become permanent for some going forward. As a result, some workers are now wondering if they are eligible to take advantage of an IRS tax break for home offices. In this article I will discuss the pros and cons of the deduction and what are the requirements to qualify for the home office deduction IRS Publication 587 Business Use of Your Home.
So you have been working remotely during COVID-19. Can you take a home office tax deduction?
Over the last few almost everyone I have spoken to has been asking about this deduction since we all have been working from home (myself included) due to Covid-19 restrictions. So does working from your home this past year qualify you for this deduction? It's a little more complex of an answer, especially if you are not a self employed business owner or partner. Even though the dining room may have been transformed into a makeshift conference room, this deduction has many rules and recent tax law changes that may curtail wide use. The law, as modified by the Tax Cuts and Jobs Act, mainly applies to self-employed individuals and small business owners, meaning employees do not qualify. Now let's dive a little deeper into the details around the home office deduction and the eligibility requirements.
Does my Home Qualify as an Office?
In order to qualify for the deduction, a taxpayer must have a dedicated area of the home used exclusively for conducting business on a regular basis. Now the IRS defines a home for the purposes of this deduction as a house, apartment, condo, mobile home or boat, and also includes structures on the property like a detached garage, greenhouse, studio or barn. Here is an important detail, “the home must serve as the taxpayer’s principal place of business. Overlap with other activities outside of business can disqualify a space.
Generally speaking, to qualify for the home office deduction:
Exclusive and regular use: You must use a portion of your home exclusively and regularly for your business.
Principal place of business: Your home office must be either the principal location of that business, or a place where you regularly meet with customers or clients.
Exceptions: Some exceptions to these rules, such as for daycare and storage facilities, are discussed below.
A SEPARATE STRUCTURE
The Journal of Accountancy published an article on the subject and explains that “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)).
Miscellaneous Itemized Deductions Suspended Through 2025
In 2017, the Republicans and then President Trump signed a new tax reform bill called the The Tax Cuts and Jobs Act, that lowered the Individual tax rate and in order to pay for some of it they suspended the miscellaneous itemized deduction for tax years 2018 through 2025.
With this change, it suspended a category of deduction which includes unreimbursed employee business expenses, including those associated with setting up and maintaining a home office. Meaning for most working professional taxpayers (non self employed or owner) this deduction is not available until the end of 2025, barring future legislative action.
The Home office Deduction Rules and Caveats
A few things to keep in mind about taking this home office deduction:
You have to keep records, fill out extra tax forms (Form 8829)
You need to track your expenses and deductions
Figuring out direct vs indirect expenses to be used in the calculation
Upfront home improvement expenses of building the office especially if you hire a contractor
How the home office deduction can affect your tax bill when you finally sell your home.
Figuring out the depreciation
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.
Dealing with the depreciation
Once you have determined that as a taxpayer you can qualify and take the home office deduction, homeowners can also now depreciate (which would account for the normal wear and tear of the building structure not the land) the office used for the business part of the home. Also permanent improvements that were made to make the home office can also be depreciated also. Remember when you go to sell the home that depreciation of the home office has to be recaptured as ordinary income once it is sold. Meaning, the cumulative amount of depreciation deducted is not eligible for the primary residence sale exclusion. So if you are going to file for this deduction and write off expenses related to your home office, be sure to take the depreciation deduction. Why? You’ll have to recapture that depreciation (i.e., pay taxes) when you sell — even if you never took the deduction.
So for example if we take a look at the simplest situation, where we’re talking about an office within the actual house, the home office depreciation that was taken on prior returns must be accounted for when you sell. In an ordinary home sale, you get a chunk of money that’s completely tax free, not so when a portion of your home has been used as “Commercial Office Space”, this portion of the home office is taxable. Single homeowners who sell don’t have to pay taxes on up to $250,000 in profit; the exclusion amount is double for married taxpayers who file joint returns.
But these primary residence tax free capital gains exclusion rules don’t apply to business property and a home office is considered business property.
Understanding unrecaptured gain
I want people to understand that even if you stay within the confines of the exclusion limit, you still might face some home office-related tax costs. How does it work? The issue arises when the IRS “recaptures” the tax on the depreciation of any business use of a sold property. Meaning, the IRS wants to make sure the Treasury gets back some of the depreciation benefits you claimed over the years.
This recaptured depreciation is taxed regardless of whether your overall gain is more or less than your allowable home sale exclusion amount. And it’s taxed at a rate higher than the typical capital gains rate with which most investors are familiar.
Let's look at an example.
Let’s say that John Smith, a single taxpayer, purchased a home in 2010, immediately set up a home office in one room and correctly deducted expenses and depreciation.
Over the years, he claimed $10,000 in depreciation on his tax returns.
This year he sold his home and has a profit of $100,000.
His gain is well under the allowable $250,000 tax-free residential sale exclusion. But of that $100,000, the $10,000 that is allocable to the depreciation claimed on his home office over the years is considered taxable gain.
You might read this and say it's only $10,000 and you are thinking that the benefits you will receive, over the years, by claiming the home office deductions and associated depreciation will provide you substantial tax savings.
Although you report it on Schedule D, the form used to detail all your capital gain transactions, it has its own more-costly tax treatment
Unrecaptured Section 1250 gain
This is a class of capital gains that is taxable at a maximum 25 percent rate rather than the 10 percent to 15 percent rate that is available if you’re selling stock or other assets.
In essence, because you’ve mixed business and residential use of the property, the depreciation deduction you claimed over the years for that home office is really just a deferral of taxes into the year when you sell the residence. And the 25 percent rate applies regardless of your ordinary income tax bracket.
What if you didn’t depreciate your home office? You wrote off the space and proportionate utility and maintenance costs, as well as a portion of your rent or mortgage payment, but didn’t bother with the depreciation calculations or claim it on your tax return. Do you still have to recapture the Section 1250 costs?
Unrecaptured Section 1250 gain is the portion of a capital gain related to the amount a property has already been depreciated. Any portion of the sale price of real estate that was previously depreciated is subject to a higher capital gain rate, which is usually 25%. Normally unrecaptured Section 1250 gain only applies to depreciable real estate, such as commercial real estate and residential rental properties.
Unfortunately for homeowners, this is true. This unrecaptured Section 1250 rule, according to IRS language, applies with respect to depreciation that is either allowed or allowable. Basically, you get stuck with it if you’re entitled to take it, regardless of whether you’ve actually taken it.
The way the rule reads, and this also is for commercial and rental real estate, is that you are imputed depreciation deductions even if you don’t take them. You have to depreciate what you are claiming as business use.
Because simply deciding against claiming the depreciation amount doesn’t absolve you of owing taxes on it when you sell, you might as well go ahead and get the benefit of it while you’re using your home office.
How to calculate the home office business deduction
Your home office business deductions are based on the percentage of your home used for the business or a simplified square footage calculation.
Business percentage of house method:
The most exact way to figure this proportion is to measure the square footage devoted to your home office and find what percentage it is of the total area of your home.
If the office measures 150 square feet, for example, and the total area of the house is 1,200 square feet, your business percentage would be 12.5%.
150 square feet ÷ 1,200 square feet = 0.125 (12.5%)
An easier way is acceptable if the rooms in your home are all about the same size. In that case, you can figure the business percentage by dividing the number of rooms used in your business by the total number of rooms in the house.
A few years ago the IRS introduced the simplified method, which was supposed to ease up the burden of recordkeeping for the taxpayer for determining the home office deduction amount. Instead of tracking separate expenditures of the home as described above, merely multiply $5 by the allowable square footage of the business portion of the home (using the smaller of 300 square feet or the actual space). The deduction cannot exceed the net income (receipts less non home-related expenses) from the business use of the home. Using this method means taxpayers do not need to adjust the amount of mortgage interest or real estate tax reported on Schedule A when itemizing deductions.
The home office space is also not depreciated under the simplified method (meaning no recapture is necessary upon subsequent sale).
Taxpayers can switch between choosing to use the actual expenses one year and then use the simplified method in another year. But remember, that any carryover of actual expenses cannot be used in a tax year when the simplified method is used to compute the home office deduction. So just remember that with either method, the qualification for the home office deduction is determined each year.
These rules are complicated, when it would seem to be a very simple concept, I work from home now due to the Covid restrictions….I should be able to deduct some costs….To convince the IRS that, according to the tax rules, your workspace is not a true home office, if you also could, for example, use the room to maintain your personal financial records or have a TV in there where the kids are allowed to watch DVDs.
The bottomline is that one of my goals is to provide guidance and educate readers and clients on the rules, pros and cons of certain accounting, tax savings and retirement strategies. And if you are a small business owner, self-employed or a partner and are interested in taking this deduction, don't get caught off guard with unrecaptured Section 1250 gains. Find out how much of your capital gains is unrecaptured Section 1250 gains and how much you can expect to be taxed on it. I don’t discourage taxpayers from taking it (the home office deduction), but I definitely explain the rules if they’re going to take it. Then I go through it in more detail to see if it will really be beneficial. You don’t want any tax surprises when you sell your home. Have any questions feel free to reach out for a discussion.
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