Sec. 280A(c) permits self-employed individuals and employees who work out of their home to deduct business expenses relating to the part of their home that is exclusively used on a regular basis to carry on a trade or business, or, in the case of an employee, the person has no other fixed location to perform his or her job duties. Exclusive means just that-the space is never used for a nonbusiness purpose and is regularly used for meeting with clients or customers and/or performing administrative and management activities.
If an employee works at home for his or her convenience rather than for the employer's convenience, the deduction is not allowed.1 In limited circumstances, primarily when the home is the sole, fixed location of the trade or business, space used to store inventory or product samples may also be counted as business use.2 It is also important to note that certain day care providers may take a limited deduction even when the space does not meet the exclusive use requirement.3
Starting with the 2013 tax year, the IRS is offering a safe-harbor alternative to the home office deduction individual taxpayers can claim.4 Traditionally, the Sec. 280A home office deduction requires complex computations and allocations and burdensome recordkeeping. The new alternative is a simplified method in which the taxpayer multiplies the total square footage of the business portion of the personal residence by $5. What could be simpler than multiplying the length and width of the office space to get the total square footage of the business portion of the home? But before deciding to use the simplified method, its costs and benefits should be evaluated. While many taxpayers will adopt this new method in the interests of simplicity, there are certain instances, discussed later, where simple may not be better.
A recent article in The Tax Adviser 5 provides a detailed history of the home office deduction, describes the actual-cost and safe-harbor methods, and provides several examples comparing the two methods. This article is not intended to repeat that excellent summary, but to provide the results of a sensitivity analysis6 of the benefits of the two methods for taking the home office deduction across a range of three variables: the square footage of the home office, the total cost of the residence, and the marginal tax rate. An Excel spreadsheet, available here, illustrates this analysis. First, a simple example demonstrates the basic computations of the home office deduction using both actual costs and the safe-harbor method, followed by a sensitivity analysis and summary of results. Finally, the key factors to consider when electing the safe-harbor method are discussed.
Comparing the Two Deduction Methods: An Example
Example 1: A has net income from her business before the home office deduction of $5,600. She purchased her residence for $100,000, excluding the cost of the land, has a home office of 350 square feet (10% of the house's total square footage of 3,500) and has a marginal tax rate of 15%. She paid $10,000 in mortgage interest and $3,000 in real estate taxes. The total indirect costs of operating the residence (utilities, insurance, and repairs and maintenance) are $4,800. The depreciation expense on the business portion of the residence is $256. The total deductions under each method are provided in Exhibit 1.
Actual-Cost Deduction: Observations
The home office actual-cost deduction has three components, as defined in Sec. 280A(c)(5):
• Tier I deductions: Interest and real estate taxes on the home, which are deductible whether or not the space is used for business purposes. In this example, the total is $1,300 (10% of the $10,000 interest and $3,000 taxes).
• Tier II deductions: Expenses that benefit both the business and personal portions of the home, such as insurance, utilities, and repairs and maintenance. These expenses may be deductible in full if directly related to the business portion of the home, such as painting the walls in the business use portion, or partially deductible if indirectly related, such as the monthly electric bill for electricity provided to the entire home. In this example, the total is assumed to be $4,800.
• Tier III deductions: Allowable depreciation on the business portion of the building, usually computed on a 39-year useful life. In this example, the depreciation is computed to be $256.
Simplified Safe-Harbor Method: Observations
• The simplified safe-harbor deduction is limited to a maximum of 300 square feet multiplied by $5 per square foot.
• Since the safe-harbor deduction is in lieu of any Tier I, Tier II, or Tier III deductions, the interest and taxes attributable to the home office use are deducted on Schedule A as itemized deductions.
Refining the Analysis
Based on the above analysis, it would appear that the taxpayer would have a net tax savings of $115 from the additional deductions under the simplified method ($764 × 15%). However, to accurately determine the total tax savings, the following considerations should be evaluated:
- Both the taxpayer's regular income tax and self-employment tax must be computed under each method. Since interest and taxes allocable to the home office deduction are deducted on Schedule A, Itemized Deductions, and not Schedule C, Profit or Loss From Business (Sole Proprietorship), with the simplified method, the self-employment tax is likely to be larger with the simplified method. However, this may be offset with the income tax savings from these two increased itemized deductions.
- The tax cost of the taxable gain from the depreciation recapture when the residence is sold must also be considered. The Tier III deduction for depreciation may result in a taxable gain when the residence is sold, because of the special Sec. 121 recapture rules. Normally, the gain on the sale of a personal residence is tax free provided the gain falls within the allowable exclusion limits (normally $250,000 for a single taxpayer and $500,000 for a married taxpayer filing jointly).7 However, gain attributable to the accumulated depreciation taken on the residence is taxed at 25% or the taxpayer's marginal tax rate, if less.8
- The simplified method will also increase the taxpayer's adjusted gross income (AGI), which may adversely affect deductions and other computations based on AGI and may lead to a loss in total itemized deductions and personal exemption deductions because of required phaseouts.9
When these items are factored into the computations, the net results change as illustrated in Exhibit 2.
Note that the $75 increase in self-employment tax is offset by the $120 reduction in the regular income tax. Under the simplified method, there is no recapture tax when the residence is sold. The tax benefit of avoiding recapture is reduced as the number of years into the future that the gain on the sale of the residence would be recognized is increased (i.e., the present value of the tax on the recapture gain decreases as the years to the date of sale increase).
Advantages and Disadvantages of the Safe-Harbor Method: A Closer Look
The safe-harbor method to claim the home office deduction has several advantages:
- In many cases, the method may offer a larger home office deduction;
- The method greatly reduces the taxpayer's recordkeeping burden;10
- The safe-harbor amount is not in lieu of interest and taxes-those amounts related to the office in the home are still deductible on Schedule A;
- The possible increase in self-employment income may lead to slightly higher Social Security benefits at retirement;
- A taxpayer may change from the actual-cost method to the safe harbor on a year-by-year basis-it is not treated as a change in accounting method;
- Tax return preparation costs may be reduced, if the charge varies with the number of schedules prepared or the complexity of the return; and
- In any year that the safe-harbor method is used, the depreciation taken in that year is presumed to be $0-basis is reduced only when actual costs are used in the computation.11
The safe-harbor method also has its disadvantages:
- It is likely to increase self-employment taxes (although this is partially offset with the deduction from AGI for one-half of the self-employment tax);
- If the home office deduction causes a loss from the related business, that loss may not be carried over to future years (any unused Tier II and Tier III expenses under the actual-cost method may be carried forward and used in future years);
- While the safe-harbor election is made on a year-by-year basis, once an election is made, it is considered to be irrevocable and may not be changed on an amended return;
- The increase in AGI with the safe-harbor method may reduce certain itemized deductions with AGI floors and, for higher-income taxpayers, may increase the phaseouts of itemized deductions (3% of the increase in AGI) and exemption deductions (2% of the deduction if the increased AGI causes the total AGI divided by $2,500 to "round up" to a higher number); and
- The increase in AGI could significantly affect certain deductions for AGI.
As an example of this last point, recall that Sec. 469(i)(2) provides an exception to the nondeductibility of a net passive activity loss incurred during the tax year: The first $25,000 of losses on qualified residential rental real estate activities "escape" the passive basket and may offset any type of income (active or passive). However, the $25,000 maximum exception is phased out by 50 cents for every $1 of AGI exceeding $100,000. Thus, taxpayers with AGIs between $100,000 and $150,000 may lose passive deductions they would have qualified for under the actual-cost method if their AGI increases under the simplified method.
Example 2: Taxpayer B has $140,000 AGI for the year and deducts $5,000 of her $12,000 passive rental loss under the $25,000 rental real estate exception to the Sec. 469 passive activity limitations. Assume B uses the simplified method for computing home office expenses, which increases her AGI by $500. This increase in AGI reduces her passive loss deduction by $250 ($500 × $0.50).
If an unusual Tier II expense is incurred in the current tax year, it may be preferable to use the actual-cost method for that tax year; the safe-harbor amount is not adjusted in this case.
Evaluating the Deduction Decision: A Sensitivity Analysis
Example 3: Due to an unusually wet spring in 2013, the ceiling and walls in taxpayer C's home office were infested with an allergy-causing mold. C spent $1,200 to have the affected areas treated and repainted. Since no tax benefit would result from this expenditure under the simplified method, C should elect to compute the home office deduction using actual costs on Form 8829, Expenses for Business Use of Your Home.
While the simplified method benefited the taxpayer in Example 1, does this result apply to all taxpayers? To answer this question, a sensitivity analysis is used to determine which taxpayers are likely to benefit the most (or the least) from the simplified method. This analysis varied the square footage of the home office, the total cost of the residence, and the marginal tax rate. The Tier I, II, and III indirect expenses were computed using the percentages shown in Exhibit 3. The house was assumed to be 3,000 square feet.
The results indicate that for most taxpayers who have a business office, the simplified method is generally preferable when the cost of the residence is $200,000 or less. When the cost of the residence is $300,000 or more, the actual-cost method is preferable. When the cost of the residence is between $200,000 and $300,000, the decision to use the simplified method depends on the marginal tax rate and the business use percentage.
The results of the simulations are presented in Exhibit 4, Exhibit 5, Exhibit 6, Exhibit 7, and Exhibit 8.
The IRS is to be commended for offering a simple alternative to the complex home office deduction. Yet, simplicity does not always result in additional tax savings. As this analysis shows, taxpayers could save at most only a few hundred dollars by using the simplified method. The tax benefits of the simplified method decrease as the cost of the residence increases and as the taxpayer's marginal tax rate increases. For self-employed taxpayers, the increase in the self-employment tax may negate the income tax savings from the simplified method.
Fortunately, the simplified method is an annual election, so a taxpayer whose marginal tax rate fluctuates from year to year may find the optimal strategy is to claim the simplified method in low-marginal-tax-rate years and the regular method in high-marginal-tax-rate years. However, this strategy defeats the purpose of the simplified method since the deduction would have to be computed under both methods annually.
If the tax return preparer charges a fee based on the number of schedules attached to the return, then omitting Form 8829 may save the taxpayer money. Thus, when the tax cost from the simplified method is a de minimis amount, say $100 or less, taxpayers should use the simplified method, since the reduction in the tax preparation fee by not having to prepare Form 8829 may offset the additional tax cost. Some taxpayers may have other issues, such as the phaseout of the passive activity rental loss limitation exception or the phaseout of certain itemized deductions, which come into play when AGI increases, that should be taken into account when deciding whether to use the simplified method. Since the results may vary by taxpayer, an Excel spreadsheet in which the taxpayer's specific information can be entered to compute the tax savings (cost) of the simplified method is available here.
1 Sec. 280A(c)(1) (flush language).
2 Sec. 280A(c)(2).
3 Sec. 280A(c)(4).
4 Rev. Proc. 2013-13.
5 Morrow, Rupert, and Zullo, "Rev. Proc. 2013-13: A New Option for the Home Office Deduction," 44 The Tax Adviser 522 (August 2013).
6 "The study of how uncertainty in the output of a model (numerical or otherwise) can be apportioned to different sources of uncertainty in the model input" (Saltelli, et al., Global Sensitivity Analysis: The Primer §1.1.1 (John Wiley & Sons 2008)).
7 Sec. 121(b).
8 Sec. 1(h)(1)(E).
9 Secs. 68 and 151.
10 The IRS estimates the simplified method will save 1.6 million hours of tax preparation time annually (IR 2014-24 (March 7, 2014)).
11 The simplified home office method and the standard mileage method for autos have some similarities; for example, there are limits on how many properties may qualify for the simplified procedure. However, the standard mileage rate rule requires a reduction for "deemed depreciation" in years in which the standard mileage method is used (see Rev. Proc. 2010-51), while the simplified method does not.