May 20, 2016

“No Place Like Home” Office Deduction

Betty J. Boyd

“Toto, we’re home!” If you are working from home or thinking about working from home, you may be able to reduce your taxes by deducting otherwise nondeductible personal expenses attributed to your business.

When determining federal taxes, an individual generally cannot deduct personal, living, or family expenses from his or her income. However, section 280A of the Internal Revenue Code (IRC) provides an exception to this rule for individuals and S-corporations (pass-through entities in which individual shareholders are subject to taxes) that meet this section’s requirements. Section 280A(c) allows an individual to claim a home office deduction, by deducting expenses incurred in operating a home office.

Where and how the home office deduction is claimed depends on the type of business entity. The home office deduction will appear on Schedule C (attached to Form 1040), if the individual is either a sole proprietor or a member of a disregarded single-member limited liability company (LLC). Alternatively, home office expenditures will be reflected as an unreimbursed partnership expense on Schedule E (attached to Form 1040), if the individual is a partner from either a partnership or an LLC taxed as a partnership. The critical requirements are that these expenses are (1) ordinary (i.e., common and accepted) and necessary (i.e., helpful and appropriate) to the partner’s trade or business, and (2) required under the partnership agreement.

Importantly, section 280A does not allow C-corporations (entities that pay taxes separately from their shareholders) and LLCs taxed as a C-corporation to claim a home office deduction. This does not prevent a C-corporation from leasing home office space from an employee. However, a different set of rules apply to this arrangement. A C-corporation may deduct payments made for the lease of a home office, under IRC section 162, as rental payments – if they are ordinary and necessary to the corporation’s trade or business. In turn, employee lessors must report these rental payments as income on Schedule E (attached to Form 1040) without any offsetting home office deduction – due to the limitation under section 280A(c)(6).

This article briefly examines how the section 280A rules (the home office deduction) applies to self-employed individuals and to employees, as well as the section’s calculation methods.

Follow the Section 280A Road

Whether you are a renter or a homeowner, you may claim a home office deduction, as a self-employed individual or as an employee working at home (for the convenience of your employer) so long as you satisfy the requirements set forth in section 280A.

First, you must designate a specific area of your home exclusively for business use. This designated space must be separately identifiable from the personal (or recreational) area of your home. This requirement is an “all-or-nothing” standard: either it is used completely for business purposes or it is not.

Second, you must regularly use this designated area to perform your business. For example, you may use the designated space to talk with your clients on the telephone for several hours, five days a week. All the surrounding facts and circumstances are considered in determining whether you meet this condition.

Third, your home office must be one of the following:

  1. your principal place of business;
  2. a space where you meet or deal with clients, in the normal course of business; or
  3. a detached, separate structure (e.g., studio) used for your business.

Let us consider these requirements in more detail.

Use Your Brains: Make It Your Principal Place of Business

One possible way to be able to deduct your home office expenses is to use your home as your “principal place of business.” This means that your home is the most important, consequential, or influential place where you work. If your home office is the only place where you work, then you meet this prerequisite. However, if you conduct your work at other locations, then other factors, such as the following will be considered, on a case-by-case basis:

  1. the amount of time you spend at your home office (compared to time spent at all other work locations);
  2. the importance of the business functions you perform at your home office;
  3. the necessity of maintaining your home office; and
  4. the expenditures to establish your home office.

The first two factors are the most important, as set forth in Commissioner v. Soliman (1993) 506 U.S. 168, 175, 177. If you work in different locations, you may use a safe harbor for performing your business’s administrative or management activities (e.g., billing clients and keeping records) if your home office is the only fixed location where you perform these activities.

Have Heart: Meet Your Clients in the Normal Course of Business

A second possible way to qualify for the home office deduction is to demonstrate that (1) you physically meet or deal with clients at your home office; and (2) your clients’ use of your home is substantial and integral to the conduct of your business.

Thus, your home office does not need to be your principal place of business (you may conduct business in another location), as long as you regularly meet or deal with your clients in your home office, during the normal course of business. This means that you meet your clients in your residential office, more often than incidentally or occasionally. For example, in one case, the consultant taxpayer was disqualified to claim the home office deduction, because he met his clients at his home office 5 or 10 times a year.

Do Not Fear: You Can Always Use a Separate, Detached Structure, Exclusively and Regularly for Business

A third way to qualify for the home office deduction, is to designate a separate, free-standing structure (such as a detached garage), used exclusively and regularly in connection with your trade or business. The structure does not need to be your principal place of business or a place where you meet clients, as long as it is exclusively and regularly used in connection with your business. Because the “in connection” standard is less strict, you may find it easier to be qualified for a home office deduction, with a detached structure.

As an Employee, Respect Your Wizard: Your Home Office Must Be “For the Convenience of the Employer”

If you are an employee, there is an additional requirement: The use of your home office must be “for the convenience of the employer” – and not merely appropriate and helpful. This does not mean that you decide to choose to do some of your work at home; it must be part of your job requirements. The fact that an employer does not provide you with adequate office space is a factor in the consideration of this requirement, but it is not dispositive. On the other hand, if working from home is part of your employment contract, then this fact will be in your favor.

As explained above, the key restriction is that, if you are an employee who is renting a home office space to your employer, you cannot take the home office deduction for this same space. Your employer can take a rental deduction (under section 162) for payments made to you; but you must report this rental income on your Schedule E and not offset it with the home office deduction. In other words, there is no double dipping: either the corporation claims a section 162 deduction for the ordinary and necessary use of the office space in the employee’s home or the employee claims a home office deduction.

You may, however, deduct other expenses, such as mortgage interest and property tax, regardless of the business use of your house.

Calculations, Tax Forms, and Gross Income Limitations! Oh My!

Once you have met all the above requirements, you may decide between two methods of calculation: (1) the regular (or traditional) method; or (2) the simple method (returns filed in 2014 and thereafter). The upside of the regular method is that it allows you to deduct your actual direct and indirect home office costs. Direct expenses are those paid only for the business portion of your house (e.g., painting and repairs only in your home office). These are fully deductible.

By contrast, indirect expenses are those paid to keep up and run your entire home (e.g. utilities for the entire house). Only a business percentage of the indirect expenditures, relative to the size of the home office, are deductible. The business percentage may be calculated by any reasonable method, such as your home office’s square footage divided by your residence’s entire square footage. For example, if your home office is 300 square feet and your house’s total square footage is 3,000, then your business percentage is 10 percent. Alternatively, if your three-story townhome has equal-sized floors and your home office consists of the entire first floor, then your business percentage may be calculated as 33.3 percent. However, unrelated expenses, which are expenses exclusively for personal use (e.g., painting the nursery room) are non-deductible.

The downside of the regular method is that it requires the maintenance of accurate records and completing Form 8829. This may be daunting depending on how you feel about keeping track of all your home office expenditures and completing another IRS form.

As an alternative, the IRS provides a safe-harbor method, otherwise known as the simple method, to lessen the burden of calculating, allocating, and substantiating actual expenses. This method is calculated by using a flat rate of $5 per square foot of your home office (not to exceed 300 square feet or $1,500). When using this method, you do not need to complete Form 8829. You only need to report the deduction on your Schedule C (Line 30, for self-employed individuals) or Schedule A (Line 21, job expenses, for employees).

Once you choose a method for a particular tax year, you cannot change it midyear. You may, however, choose the simple method during one year and the regular method during the next. Regardless of the method you choose, you may not deduct your indirect expenses (i.e., running your home), in excess of the total gross income earned from your home business (i.e., no net loss in a single tax year). When deciding, keep in mind that the regular method allows you to carry forward excess expenses to subsequent years; while, the simple method does not.

Be Aware of the Tax Consequences on the Sale of Your House

There are also other factors that homeowners should consider. A home office deduction today may subject you, as a homeowner, to a larger tax bill, when you sell your home. But, with proper tax planning, this may be minimized.

If you used the regular method to calculate your home office deduction, you must recapture, or pay back, all the depreciation you were entitled to take on your property (generally at a 25 percent rate), when you sell your house. This applies whether you actually expensed the depreciation or not. Depreciation deductions (which apply to only business – not personal – property) decrease your property’s basis, so that, when you sell your residence, it results in a greater gain. This gain, attributable to your depreciation deductions, is not excludable under IRC section 121, discussed below. On the other hand, if you used the simple method, there would be no depreciation deduction, no change in your house’s basis, and no recapture of depreciation on the sale of your residence.

Homeowners, under section 121, are allowed to exclude up to $250,000 of their capital gain ($500,000 for a married couple) from the sale of their principal residence. Generally, if you have a home office, you may apply this exclusion so long as you meet certain five-year ownership and two-year use conditions. You do not need to allocate your business and residential areas and file separate forms (e.g., Form 4797 for the business area), if your home office is either (1) within your home or (2) a separate structure (like a cottage) but not used for business during the year of sale (i.e., did not use the space for business or earn any business income from that area, and used it only for residential purposes).

However, if your home office is a separate structure and you used it for business, during the year of sale, then you need to allocate your gain between the business area and the personal area. section 121 does not apply to the business part of your house – only to the residential portion. You must report the sale of the business part on Form 4797.

Generally, the business part is calculated by the same method used to determine your depreciation adjustments (e.g., the business percentage described above); however, if you made substantial improvements to your business portion, it may be beyond this basic business percentage. An appraiser may be helpful in that case.

Let us look at an example. You purchased your house (which includes a detached guest house that is measured as 10 percent of your total residence) for $500,000. Five years or more later you sell your house for $800,000. Over the years, using the regular method, you depreciated $10,000 of your home office. Now, let us look at three variations:

  1. Your home office is your spare bedroom. You meet the section 121 ownership and use tests. No allocation (or Form 4797) is needed. Your business usage does not affect your gain/loss calculations. However, you need to pay back the $10,000 depreciation deductions you took. (If you used the simple method, then there are no depreciation deductions to recapture.)
  2. Your home office is a detached guest house. You met the ownership and use requirements under section 121, and you did not use it for business during the year you sold your house. Same results as above.
  3. Your home office is a detached guest house. You met the residential use requirements for the residential portion of your home but not for the separate structure which you used as a home office during the entire time you owned the home. In this case, you need to allocate the basis and amount realized between your property’s business portion and personal portion, by treating the sale of your house as two different transactions (and completing the business portion on Form 4797): 

BUSINESS PORTION (Guest House’s Size is 10 Percent of House’s Total Size)

Amount Realized

$80,000 (10% of $800,000)

Subtract Basis

$40,000 (10% of $500,000–$10,000 depreciation)

Recognized Gain

$40,000 (Reported on Form 4797)

$30,000 of this gain ($80,000 – the allocated original basis of $50,000) is treated as the sale of business property and classified as section 1231 gain. $10,000 of the gain (due to depreciation) is taxed at the recapture rate (generally 25 percent).

RESIDENTIAL PORTION

Amount Realized

$720,000 (90% of $800,000)

Subtract Basis

$450,000 (90% of $500,000)

Capital Gain

$270,000 (Reported on Form 8949/Schedule D)

Subtract § 121 Exclusion

$250,000 (for single taxpayers who meet the ownership and use tests)

Recognized Gain

$20,000 (Reported on Form 8949/Schedule D)

As mentioned above, the standard for claiming a deduction for a separate-structure home office may be easier, but it may complicate the reporting of the sale of your house on your federal tax return. Get ready to call your accountant!

Somewhere Over the Rainbow, There is a Deduction!

Justifying a home office deduction requires diligence. Make sure you meet all the home office requirements and keep accurate records to back it up. Although not required, it is advisable to keep updated photographs and diagrams of your home office and to partition your home office from the rest of your living areas (unless your office is in a separate building). Finally, keep logs to show Uncle Sam that you regularly use your home office for your business. Consult with a tax professional if you are uncertain about the requirements, calculations, or forms. That way, during tax season, you can be assured, “There is no place like your home office!”

Betty J. Boyd

Betty J. Boyd is a solo practitioner in Monterey Park, California, specializing in tax controversy and business litigation in the greater Los Angeles and Orange County areas.