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As millions of employees are sent home or continue working remotely due to the coronavirus (COVID-19) pandemic, many taxpayers have experienced a commensurate increase in home office related expenses. In prior years, regulations and published guidance specifying the eligibility to claim home office deductions involved fact-specific tests and thresholds that were often difficult to satisfy and rarely yielded tax benefits. However, given the dramatic shift in the regularity and exclusivity of home office usage, there exists an opportunity to examine the possible tax benefits of qualifying home office expenses for 2020 and beyond.
Unfortunately, employee business expense deductions (including the expenses of maintaining a home office) are considered miscellaneous itemized deductions and are therefore disallowed from 2018 through 2025. However, self-employed taxpayers may be eligible for an ‘above-the-line’ tax deduction for home office expenses if they satisfy a strict set of rules. The home office deduction may include expenditures for the following:
Action item: IRS guidance specifying the requirements for self-employed taxpayers to claim a home office deduction are stringently applied, yet open to interpretation under fact-specific application. Accordingly, taxpayers must maintain clear and significant records to substantiate the home office deduction reported. Taxpayers should carefully weigh the potential tax savings against the risks before deciding to claim a home office deduction
As discussed in more detail below, for self-employed individuals to qualify to deduct expenses for business use of the home, they must use part of the home:
A home office will qualify as a principal place of business if it meets either of the following requirements:
The taxpayer satisfies the ‘administrative or management activities’ requirement if they use the home office for administrative or management activities of the business and a substantial amount of the administrative function is conducted from the home office. Taxpayers also may satisfy the relative importance test if the home office is the most important place where business is conducted, in comparison with all the other locations where they conduct such business.
To qualify under the exclusive use test, a taxpayer must use a specific area of the home solely for the trade or business. Home office expenses will be deductible if the home office is used exclusively and on a regular basis, to meet or deal with patients, clients, or customers in the normal course of the taxpayer’s duties. The area used for business can be a room or other separately identifiable space. The space does not need to be marked by a permanent partition. However, it must be used 100% of the time for business purposes. For example, if a taxpayer works in a den that their children use to watch television after business hours or presumably on weekends, the den fails the ‘exclusive use’ requirement. Two relatively uncommon exceptions to the exclusive use rule are (1) storage of inventory or product samples if the home is the sole fixed location of the trade or business, and (2) certain daycare facilities. Space used for these activities also can be used for personal purposes.
To qualify under the regular use test, the taxpayer must use a specific area of the home for business on a regular basis. Incidental or occasional business use is not regular use. Taxpayers must consider all facts and circumstances in determining whether use is on a regular basis. When considering the exclusive and regular use rules, taxpayer fact patterns may yield an objective conclusion if there exists a dedicated room in the home that is strictly a home office and is used for nothing else.
After determining the eligibility qualifications for claiming a home office deduction have been met, the taxpayer must calculate the amount of the deduction under one of two methods: the actual expense method or the simplified method.
Under the actual expense method, the deduction is determined using the actual expenses. Since expenses attributable to any part of the year the taxpayer did not use the home for business purposes cannot be deducted, the taxpayer may consider only the expenses for the timeframe in which that part of the home was used for business. For many taxpayers working at home due to COVID-19 restrictions, this timeframe will span from March through December 2020. A taxpayer also must calculate the percentage of the home that is used for the business.
To determine the business allocation percentage, compare the size of the portion of the home that is used for business to the size of the entire home. Then apply the resulting percentage to determine the business portion of the expenses for operating the entire home. Taxpayers may use any reasonable method to determine the business allocation percentage. The following are two commonly used methods for ascertaining this percentage.
The part of a home operating expense that may be used to calculate the deduction depends on whether the expense is classified as direct, indirect, or unrelated and the percentage of the home used for business. The classification of direct, indirect, and unrelated expense types is summarized below:
Certain expenses including real estate taxes, home mortgage interest, and mortgage interest premiums are deductible to the extent they would have been deductible as an itemized deduction on Form 1040 Schedule A. If the expense is indirect, use the business percentage of these expenses to determine how much to include in the total home office deduction.
Tax Tip: A benefit of taking the home office deduction is that a taxpayer may be able to allocate some of their real estate taxes to Schedule C or Schedule E. Currently, the state and local tax deduction on Schedule A is capped at $10,000 under the 2017 tax reform law.
Other household expenses are allowed as part of the home office deduction. If the expense is indirect, use the business percentage of these expenses to calculate how much to include in the total deduction. These household expenses generally include (but are not limited to) the following:
The home office deduction also includes a deduction for depreciation of the residence, provided the taxpayer owns the residence. To determine the depreciation deduction, the taxpayer must consider the month and year they started using the home for business, the adjusted basis and fair market value of the home (excluding land) at the time they began using it for business, and the cost of any improvements before and after they began using the property for business. The depreciable basis is calculated by multiplying the percentage of the home used for business by the lesser of the following:
If the taxpayer began using the home for business for the first time in 2020, in most cases, the business portion of the home should be depreciated as nonresidential real property under MACRS using the straight-line method over 39 years. As with most other depreciation circumstances, the distinction between repairs and permanent improvements must be considered.
Planning note: If the house is sold—at a profit—a home that contains, or contained, a home office, the otherwise available $250,000/$500,000 exclusion for gain on the sale of a principal residence will not apply to the portion of the profit equal to the amount of depreciation that was actually claimed (or allowed to be claimed) on the home office. In addition, the exclusion will not apply to the portion of the profit allocable to a home office that is separate from the dwelling unit or to any gain allocable to a period of nonqualified use (i.e., a period that the residence is not used as the principal residence of the taxpayer or their spouse or former spouse) after December 31, 2008. Otherwise, the home office will not affect their eligibility for the exclusion.
In addition to a home office deduction, a taxpayer may have common furniture items that, if used in their trade or business, qualify as tangible personal property eligible for depreciation under the more favorable 7-year MACRS recovery periods, including expense under Section 179. This could include:
Note: These assets have to be used in the taxpayer's trade or business and meet the ordinary and necessary criteria of Section 162 to be deductible.
The simplified method is an alternative to the calculation, allocation, and substantiation of actual expenses. The deduction will be determined by multiplying $5, the prescribed rate, by the area of the home used for a qualified business use. The area used to calculate the deduction is limited to 300 square feet. Therefore, the maximum deduction allowable under the simplified method is $1,500. This deduction must be adjusted for the number of months the taxpayer uses the office for business purposes, if they did not use the office the entire year.
If the taxpayer elects to use the simplified method, they cannot deduct any actual expenses for the business except for business expenses that are not related to the use of the home. The taxpayer also cannot deduct any depreciation (including any additional first-year depreciation) or Section 179 expense for the portion of the home that is used for a qualified business use. When using the simplified method, treat as personal expenses the mortgage interest, real estate taxes, and casualty losses. A change from using the simplified method in one year to actual expenses in a succeeding tax year, or vice versa, is not a change in method of accounting and does not require IRS consent.
In prior tax years, the ability for a self-employed individual to claim a home office deduction was typically prohibited by unfavorable taxpayer fact patterns that included the lack of a requirement to work from home or the availability of adequate office space provided by the company. Such barriers to satisfying eligibility to claim a home office deduction are no longer applicable under most circumstances for these individuals.
If eligibility requirements are satisfied, self-employed taxpayers must weigh the costs and benefits of claiming a home office deduction under the simplified method or the actual expense method, acknowledging additional record keeping requirements must be adhered to.
Personal Financial Services Leader, PwC US