Bulletins

New Safe-harbor Allowance for Home Offices and Other Business Uses of a Home

by Daniel A. Kosmatka, CPA, PFS, CFF, CGMA

Dear clients and friends,

The IRS has established a new, simplified, safe-harbor method that individual taxpayers can elect to use to determine deductions related to the business use of their home, such as a home office. The new method is allowed for tax years beginning on or after 1/1/13.

The new safe-harbor method does not change the rules regarding when home-related business deductions are allowed. It only provides a simplified method for calculating deductions- when they are allowed. This letter explains what you need to know about the new method, but let's first revisit the basic rules for home-related business deductions.

Home-related Deduction Basics

The general rule states that no deductions are allowed for the business use of a dwelling unit that's also used by the taxpayer as a residence during the tax year in question. Thankfully, certain exceptions to the general rule allow for direct expenses and the business-use part of the indirect expenses relating to the business use of a residence if certain requirements are met. Specifically-

1. Home Office. Properly calculated and substantiated home office deductions are allowed if part of the home is used regularly and exclusively as a principal place of business or as a place to meet or deal with customers or clients in the ordinary course of business. In the case of a detached separate structure (such as a converted barn, detached garage, or pool house), deductions are allowed if the structure is used regularly and exclusively in connection with the taxpayer's business. Employees must pass an additional test to claim deductions-the use of the home office must be for the convenience of the employer. A home office qualifies as the principal place of business if most of the income-earning activities occur there. However, a home office can also be a principal place of business if the taxpayer's administrative or management activities are conducted there, and there is no other fixed location where the taxpayer conducts substantial administrative or management activities.

2. Inventory Storage Space. Expenses allocable to space in a dwelling unit that's used on a regular basis for storing inventory or product samples kept for use in the taxpayer's business of retail or wholesale selling of products are deductible if the dwelling unit is the sole fixed location of the business. Exclusive use of the space for such purpose is not required (regular use is required).

3. Daycare Business. Expenses allocable to the part of a dwelling unit that's used on a regular basis in the taxpayer's 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. Exclusive use of the space for such purposes is not required (regular use is required).

Business Income Limitation. Home-related business deductions are limited to the gross income from the applicable business activity reduced by: (1) allocable home-related expenses for which deductions are allowed in the absence of business use (such as qualified residence interest, real estate taxes, and casualty losses) and (2) other business deductions that are not related to the business use of the home (such as wages, advertising, and supplies). Deductions that are disallowed under this business income limitation are carried forward to the following year, subject to the same business income limitation in that year.

New Safe-harbor Deduction Allowance

The new-safe harbor deduction method allows an eligible taxpayer to claim a deduction of $5 per square foot of space used for qualified business use, limited to 300 square feet, with no questions asked about actual expenses and no required documentation of expenses. As you can see, however, the maximum annual safe-harbor allowance is only $1,500 ($5 x 300).

Qualified business use means uses for which home office, inventory storage, or daycare business deductions would be allowed under the "regular" Section 280A rules summarized earlier. At the whim of the IRS, the $5-per-square-foot allowance can be updated from time to time.

Note: The safe-harbor method is not available to an employee with a home office if he or she 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 the employer

Impact of Using Safe-harbor Method

Home-related Itemized Deductions. Taxpayers who itemize deductions and use the safe-harbor method to calculate their home-related business deduction for the tax year in question can deduct on Schedule A any allowable expenses related to the home that are deductible without regard to business use of the home. In other words, choosing to use the safe-harbor method has no impact on the taxpayer's ability to deduct qualified residence interest, property taxes, or casualty losses. For taxpayers who use the safe-harbor method, however, no part of these itemized deduction amounts can be subtracted from business gross income in determining business net income, nor are these itemized deduction amounts taken into account in determining the home-related deduction business income limitation.

Example 1: For 2013, Alice uses 300 square feet of her residence as a qualified home office [meaning it meets the Section 280A(c)(l) requirements] and uses the safe harbor method to claim a $1,500 (300 sq. ft. x $5.00) home office deduction. She pays $10,000 of mortgage interest and $5,000 of property taxes on her residence. These amounts can be claimed as itemized deductions on Alice's Form 1040, Schedule A unreduced as a result of Alice's safe-harbor deduction for her home office.

Business Income Limitation. When the taxpayer uses the safe-harbor method, the business income limitation still applies. In other words, the safe-harbor method deduction cannot exceed the gross income from the husiness reduced by allocable business expenses (not including itemized deduction amounts, as explained earlier). Any deductions that exceed this limit are disallowed-they cannot be carried forward.

Example 2: Joe uses 300 square feet of his home for a qualified home office for all of 2013, so his tentative safe-harbor deduction is $1,500. However, Joe's net business income for 2013 is only $1,200 before considering any allowable home office deduction. Therefore, Joe's safe-harbor deduction is limited to $1,200. The $300 difference between the tentative $1,500 safe-harbor deduction and the allowed $1,200 deduction is disallowed and cannot be carried over to 2014.

Disallowed Expenses from Earlier Year. A taxpayer who uses the safe-harbor method for the tax year in question cannot deduct any amount that was disallowed by the business income limitation in an earlier year during which the taxpayer used the actual-expense method to calculate the home-related deduction. Instead, the taxpayer can deduct carried-over amounts in a later year in which the actual-expense method is used (to the extent there is sufficient business income).

Depreciation. A taxpayer who uses the safe-harbor method for the tax year in question cannot write off any depreciation (including first-year bonus depreciation or Section 179 deductions) for the part of the home that is used as a home office for that year. The allowable depreciation deduction for that part of the home for that year is deemed to be zero. The taxpayer can switch back to the actual-expense method for a later year and resume deducting depreciation. In this case, the optional depreciation table [as found in IRS Publication 946, (How To Depreciate Property)] must be used to calculate the property's remaining depreciation deduction, even if the table wasn't used in the year the property was placed in service. The applicable year to use is based on the year the property was placed in service.

Example 3: Al uses a room in his residence as a qualified home office throughout 2013. The room is 350 square feet and has a cost basis of $10,000. It was placed in service in January 2010. For 2010-2012, Al depreciates the room as nonresidential real property using the optional depreciation table, the straight-line method of depreciation, a 39-year recovery period, and the midmonth convention. As of 12/31112, the room's accumulated depreciation is $758, and its adjusted depreciated basis is $9,242.

For 2013, Al uses the safe-harbor method to claim a home office deduction, so the depreciation for the 2013 is deemed to be zero. Thus, as of 12/31/13, the room's accumulated depreciation and adjusted depreciated basis remain at $758 and $9,242, respectively.

For 2014, Al resumes using the actual-expense method for calculating his home office deduction. In 2014, the room has been placed in service for five years. According to the optional depreciation table, the depreciation rate for year five is 2.564%. Accordingly, Al deducts depreciation of $256 ($10,000 x .02564). As of 12/31/14, the room's accumulated depreciation is $ 1,014 ($758 + $256) and its adjusted depreciated basis is $8,986 ($9,242 - $256).

Electing In and Out of the Safe-harbor Method

A taxpayer can elect from year to year whether to use the safe-harbor method or the familiar actual-expense method to determine home-related deductions. A taxpayer elects the safe-harbor method simply by using that method to compute the deduction for the qualified business use of the home on a timely filed original federal income tax return for the year.

Once made, the election is irrevocable for that year. However, the taxpayer can change from the safe-harbor method to the actual-expense method, or vice versa, for a later year. Such changes are not considered accounting method changes, and no tax return statements are required to make such changes.

Conclusion

The safe-harbor method is not for everyone. Some will have substantial home office or other home-related business deductions that far exceed the safe-harbor allowance. However for people with only modest home-related business deductions, the safe-harbor method may be attractive because it eliminates the need to keep records of actual expenses.

Very truly yours,

Daniel A. Kosmatka, CPA, PFS, CFF, CGMA
Dennis W. Donnelly, CPA, PFS
Michael R. Gohde, CPA, PFS