New Method for Computing the Home Office Deduction

High unemployment rates have caused many taxpayers to utilize their homes as their primary place of business. According to the National Association for the Self-Employed (NASE), nearly half of such home-based businesses do not take a home office deduction (http://www.nase.org/Nase_News/2013/ 01/18/leam-more-about-the-simplified-homeoffice-deduction!). Numerous bills to simplify this deduction have been introduced in Congress over the past few years, without results. But the 1RS has recently issued new guidance to compute the deduction. The simplified optional safe harbor method will reduce the complexity of claiming the home office deduction, as well as the need for review by the 1RS and the courts.

Background

Internal Revenue Code (IRC) section 280A(c)(l) allows an employee or selfemployed individual to deduct the expenses of an office in the home. This deduction is allowed only if a portion of the home is used exclusively on a regular basis as either-

* the principal place of business for a trade or business of the taxpayer, or * a place of business to meet with clients, patients, or customers.

If the taxpayer claiming the deduction is an employee, the employee's use must also be for the convenience of the employer.

"Exclusive" means that a specific part of the home must be used solely for business purposes. The following exceptions do allow a portion of the home to be used for both business and personal reasons:

* Space within the home is used for storage of inventory or product samples for a wholesale or retail trade or business, and tiie home is the sole fixed location of the trade or business (IRC section 280A[c][2]). * The taxpayer is a licensed day-care provider and uses part of the home for the day-care business (IRC section 280A[c][4]).

"Principal place of business" has been a controversial definition. The term was clarified with the Tax Reform Act of 1997 (PL. 105-34, section 932[b]), and its definition now includes a place of business that-

* is used by the taxpayer to conduct the administrative or management activities of the trade or business, and

* represents the only fixed location of the trade or business where the taxpayer conducts these activities.

This expanded definition has been especially helpful to certain individuals-for example, emergency room doctors who work in multiple emergency rooms. On the other hand, it has not helped others, such as musicians who have practice rooms at home.

A home office deduction cannot exceed the gross income from the business, less all other business expenses of the trade or business. IRC section 280A requires an ordering of the expenses so that those expenses that are itemized deductions- home mortgage interest and real property taxes-must be deducted first. In addition, indirect expenses, such as depreciation on the home, utility costs, and repair expenses, must be allocated between the office in the home and the personal use of the residence. This is commonly determined based on relative square footage. Any amounts not allowed under this limitation may be carried forward and potentially deducted in future years (IRC section 280A[c][5]).

A self-employed individual must complete and attach the complicated Form 8829, Expenses for Business Use of Your Home, and include the allowable home office deduction on Schedule C of Form 1040, U.S. Individual Income Tax Return. An employee must treat the allowable office-in-home amount as an unreimbursed employee business expense and include it as a miscellaneous itemized deduction on Schedule A of Form 1040.

New Safe Harbor Method

The 1RS and the Treasury Department developed the optional safe harbor method to reduce the complexity and burden of the calculations, allocations, and substantiation requirements of the allowable home office deduction for small business owners. Revenue Procedure 2013-13 (2013-6 IRB, IR 2013-5) provides a simplified alternative to determine the office-in-home deduction amount for tax years beginning in 2013.

Under the safe harbor method, the allowable deduction is calculated by multiplying the square footage of the portion of the taxpayer's residence that is used in a qualified business, not to exceed 300 square feet, by a prescribed rate of $5. This rate may be updated by the 1RS at a later date, as warranted.

The safe harbor method may be used by an individual who satisfies the qualified business use of frie home requirements of IRC sections 280A(c)(l), (2), or (4), as described above. Under Revenue Procedure 2013-13, "home" is a dwelling unit used by the taxpayer during the year as a residence, including a dwelling unit leased by the taxpayer, if it is depreciable real property or depreciable property subject to IRC section 168 that is placed in service after December 31, 1986. The safe harbor method is not available to an employee with a home office who receives advances, allowances, or reimbursements for expenses related to the home office under an arrangement with an employer. The taxpayer can elect the safe harbor method on a yearby-year basis. A change from using the safe harbor method to using actual expenses, or vice versa, is not a change of accounting method and does not require 1RS consent; however, the election made for any given tax year is irrevocable for that year.

Taxpayers electing the safe harbor method may not deduct depreciation or any other actual expenses related to the qualified business use of the home for that year. They can, however, claim allowable itemized deductions on Schedule A for mortg3ge interest, property taxes, and casualty losses related to the home. Taxpayers may deduct allowable direct business expenses unrelated to the qualified business use of the home, such as wages, advertising, and supplies.

As with the traditional method, there is a limitation on the amount of the deduction computed under the safe harbor method. The deduction is limited to the gross income from the qualified business use of the home, reduced by the business expenses unrelated to the use of the home. Unlike the traditional method, any amount in excess of the limitation is disallowed and may not be carried over and deducted in any other year.

Special Issues

Depredation in subsequent years. If a taxpayer uses the optional safe harbor method for one tax year and the traditional method for any subsequent year, the taxpayer must use the appropriate optional depreciation table to calculate the depreciation deduction allowable in the subsequent year, regardless of whether the taxpayer used an optional depreciation table for the property in its placedin-service year. The appropriate optional depreciation table is based on the depreciation method, recovery period, and convention for the IRC section 1250 property for its placed-in-service year. The depreciation deduction for any subsequent year is calculated by multiplying the remaining adjusted depreciable basis allocable to the qualified business use of the home by the annual depreciation rate (from the optional depreciation table) for the year, that corresponds with the current tax year, based on the placed-in-service year of the property.

Carryovers. Carryovers of previously disallowed deductions from tax years using the traditional method may not be deducted in a safe harbor calculation year. A taxpayer may, however, deduct the disallowed amount in the next year in which the traditional method is used.

Allowable square footage. There are special rules for determining the allowable square footage in situations where the qualified business use of the home represents only a portion of the year or where the square footage for the business use changes during the year. The taxpayer must determine the average monthly allowable square footage, based on no more than 300 square feet for any month and including only those months in which there were 15 or more days of qualified business use. For example, a taxpayer who begins using 500 square feet of the home on September 25 and continues that use until December 31 has an average monthly allowable square footage of75 (300 square feet for October, November, and December, divided by 12 months).

Sharing a home. Taxpayers sharing a home (roommates or spouses, regardless of filing status) may each use the safe harbor method for a qualified business use of different portions of the home.

More than one qualified business use. A taxpayer who elects the safe harbor method and who has more than one qualified business use of the same home must use that method for each qualified business use of the home. The taxpayer is limited to a maximum of 300 square feet, which must be allocated among the qualified business uses in a reasonable manner.

Qualified business use of multiple homes. A taxpayer with qualified business uses of more than one home may use the safe harbor method for one home for the tax year and may use the traditional method for the business use of any other homes for that year.

The following example is adapted from Revenue Procedure 2013-13. Catherine, a graphic designer, is a sole proprietor who uses a room in her home regularly and exclusively as her principal place of business to meet with clients in the normal course of her business. The room is 324 square feet and has a cost basis of $20,000. Catherine placed the room in service in January 2013 and used it throughout the entire year. She depreciates the room under IRC section 168 as nonresidential real property using the optional depreciation table that corresponds with the general depreciation system, the straight-line method of depreciation, a 39-year recovery period, and the midmonth convention.

During 2013, Catherine earns $35,000 of gross income from her business and pays the following business expenses:

Catherine also pays the following expenses related to her home in 2013: Mortgage interest $12,000

Catherine elects the optional safe harbor method to determine the allowable deduction for qualified business use of her home for 2013. The amount of the deduction is $1,500, calculated by multiplying the allowable square footage, up to 300 square feet, by the prescribed rate of $5. The deduction is not limited, because it does not exceed Catherine's gross income from the qualified business use of her home for 2013 reduced by the business expenses, or $27,500 ($35,000 gross income - $7,500 business expenses). Catherine may also deduct her mortgage interest of $12,000 and property taxes of $4,000, to the extent allowable, as itemized deductions on Schedule A of Form 1040. She will deduct her ordinary and necessary business expenses unrelated to the qualified business use of her home of $7,500 as trade or business expenses on Schedule C of Form 1040 to the extent allowable. Under the safe harbor method, Catherine may not deduct any of the actual expenses related to the qualified business use of her home, such as homeowners' insurance, utilities, and repairs, as well as depreciation for the room.

Catherine may choose the traditional method of calculating and substantiating actual expenses rather than the safe harbor method in 2014. Accordingly, Catherine must use the appropriate optional depreciation table for year two for calculating the depreciation deduction for the room for 2014. She deducts depreciation of $512.80 ($20,000 basis x .02564 rate for year two) and her adjusted basis in the room at December 31, 2014, is $19,487.20 ($20,000 - $512.80).

A Simpler Method

The new safe harbor method will be a boon to those taxpayers who have previously avoided the office-in-home deduction because of the time and effort involved and the potential for 1RS scrutiny. Under either method, the taxpayer must be able to substantiate the qualified business use and square footage. The amount deductible under the safe harbor method, however, may be lower than the amount calculated under the traditional method, and there is no carryover available. Taxpayers may want to keep receipts and records in order to choose the method with the most tax savings each year. ?

Revenue Procedure 201313 provides a simplified alternative to determine the office-in-home deduction for tax years beginning in 2013.

Karyn Bybee Friske, PhD, CPA, is the Schaeffer Professor of Business Ethics and a professor of accounting, and Darlene Pulliam, PhD, CPA, is the Regents Professor and McCray Professor of Business and a professor of accounting, both at West Texas A&M University, Canyon, Tex.