You work from home. You know that you are entitled to deduct your “home office expenses” but your accountant has warned you that it is very tricky, and that the deduction often raises a “red flag” for the IRS or the state in reviewing your return because it is an often abused deduction. You don’t want to invite an audit and the expense of it (even if you are 100% within the law), but you are entitled to the home office deduction. What is a savvy business person to do?
The IRS feels your pain – no really, they do – and they have created a new “safe harbor” for the home office deduction. A safe harbor is an alternative to all the record keeping justifying the home office deduction. Instead, if you qualify you can deduct $5 a square foot, up to 300 square feet – or $1500. If you actually have a greater deduction calculated the old way is worth more than that, you can certainly continue to use the computer method. But, if $1500 is close or good enough, and all that record keeping can be reduced, this might be a good idea for you. After all, your job is to focus on the success of your business, not the some of the administrivia that comes with being a business owner. If this might be of interest to you, on to the legal details…..
Rev Proc 2013-13, 2013-6 IRB, IR 2013-5
In a new Revenue Procedure (Rev Proc 2013-13, 2013-6 IRB, IR 2013-5), the IRS has provided an optional safe harbor method taxpayers can use to determine the amount of their deductible home office expenses. The safe harbor is effective for tax years beginning on or after Jan. 1, 2013. The safe harbor—$5 × square feet of qualified use (up to 300 square feet – i.e. $1500) and provides an alternative to the calculation, allocation, and substantiation of actual expenses required under Code Sec. 280A.
Background. The general rule under Code Sec. 280A(a) is that no deduction is allowed for the business use of a dwelling unit that's also used by the taxpayer as a residence during the tax year. However, if strict exception requirements are met, deductions are allowed for direct expenses and the business-use part of the indirect expenses relating to business use of a residence:
Home office expenses are deductible if part of the home is used regularly and exclusively as (1) a principal place of business, or (2) as a place to meet or deal with customers or clients in the ordinary course of business. Taxpayers who are employees must meet an additional test—their use of the home office must be for the convenience of the employer. (Code Sec. 280A(c)(1))
Expenses that are allocable to space within the dwelling unit used on a regular basis for the storage of inventory or product samples held for use in the taxpayer's trade or business of selling products at retail or wholesale are deductible if the dwelling unit is the sole fixed location of the trade or business. (Code Sec. 280A(c)(2))
Expenses that are attributable to the rental of the dwelling unit or a part of the unit are deductible. (Code Sec. 280A(c)(3))
Expenses that are allocable to the part of the dwelling unit used on a regular basis in the taxpayer's trade or business of providing day care for children, for individuals who have attained age 65, or for individuals who are physically or mentally incapable of caring for themselves are deductible. (Code Sec. 280A(c)(4))
These deductions are limited to the activity's gross income reduced by all other deductible expenses that are allowable regardless of qualified use (e.g., mortgage interest, real estate taxes, and casualty losses) and by the business deductions that aren't allocable to the use of the home itself (e.g., expenses of advertising, wages, and supplies). Expenses disallowed solely because they exceed business income can be carried forward, subject to the gross income limitation in the later year. (Code Sec. 280A(c)(5))
New safe harbor. To reduce the administrative, recordkeeping, and compliance burdens of determining the allowable deduction for the qualified business use of a residence under Code Sec. 280A, Rev Proc 2013-13 provides a safe harbor method under which an individual determines his allowable deduction for the qualified business use of a home by multiplying a prescribed rate ($5) by the square footage of the part of this residence that is used for business purposes, not to exceed 300 square feet. “Qualified business use” for this purpose is a business use that satisfies the requirements of Code Sec. 280A(c)(1) through Code Sec. 280A(c)(4)—that is, uses for which a deduction under Code Sec. 280A would otherwise be allowed. The $5 rate may be updated from time to time, as warranted. Adjustments are provided for determining the allowable square footage for a taxpayer with a qualified business use of a home for only a part of a year. (Rev Proc 2013-13, Sec. 3, Rev Proc 2013-13, Sec. 4)
For purposes of the safe harbor, “home” means a dwelling unit used by the taxpayer during the tax year as a residence (as defined in Code Sec. 280A(d) and Code Sec. 280A(f)(1)), including a dwelling unit leased by a taxpayer.
The safe harbor method doesn't apply to an employee with a home office if he receives advances, allowances, or reimbursements for expenses related to the qualified business use of the employee's home under a reimbursement or other expense allowance arrangement with his employer. (Rev Proc 2013-13, Sec. 4.01(4))
The safe harbor is an alternative to deducting actual expenses. Accordingly, a taxpayer electing the safe harbor method for a tax year generally can't deduct any actual expenses related to the qualified business use of that home for that tax year, with the following exceptions:
Otherwise allowable home-related deductions. A taxpayer who itemizes deductions and uses the safe harbor may deduct any allowable expenses related to the home that are deductible without regard to whether there was a qualified business use of the home for that tax year (e.g., deductions for qualified residence interest, property taxes, and casualty losses).
Business deductions unrelated to qualified home use. A taxpayer using the safe harbor method for a tax year may deduct any allowable trade or business expenses unrelated to the qualified business use of the home for that tax year (e.g., expenses for advertising, wages, and supplies). (Rev Proc 2013-13, Sec. 4.05)
A taxpayer using the safe harbor for a tax year can't deduct any depreciation (including first-year bonus depreciation) or Code Sec. 179 expensing for the part of his home that is used in a qualified business use for that tax year. (Rev Proc 2013-13, Sec. 4.06)
A taxpayer using the safe harbor method for a tax year can't deduct any disallowed amount under Code Sec. 280A(c)(5) carried over from a prior tax year during which the taxpayer calculated and substantiated actual Code Sec. 280A expenses. He can deduct the carried-over amount in the next succeeding tax year in which he calculates and substantiates actual Code Sec. 280A expenses. (Rev Proc 2013-13, Sec. 4.08(3))
Electing the safe harbor. A taxpayer may elect from tax year to tax year whether to use the safe harbor method or calculate and substantiate actual expenses under Code Sec. 280A. A taxpayer elects the safe harbor by using the method to compute the deduction for the qualified business use of a home on his timely filed, original federal income tax return for the tax year. Once made, an election for the tax year is irrevocable.