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Since 1999, the home-office deduction is no longer a red flag — millions of Americans benefit from this deduction each year. Countless taxpayers run businesses from home, and the IRS understands this. The income-requirement rule also limits the use of this deduction for profitable enterprises, which appeases IRS concerns about abuse and hobby-loss businesses. Before the IRS liberalized home-office deduction rules in 1999, a more stringent requirement was that business taxpayers needed to meet clients in their home office. Now, the only requirement is administration work, and another principal office outside the home doesn’t negate the deduction.
Many small-business owners, including traders eligible for trader tax status (TTS), operate from a home office. Some of them also conduct their business from job locations using cloud computing, apps, and mobile devices. They can qualify for the home office expense deduction in this situation, as well. The IRS does not permit investors to take a home office deduction.
Convert personal home costs into business expense deductions. This same concept applies to many other items such as phone, Internet, furniture, fixtures, and more. Keep in mind that business income or TTS trading gains are needed to unlock most home-office deductions. If a business doesn’t have sufficient net income, the otherwise allowable home office deductions are carried over to the following tax years. (In this situation, hopefully, the person remains in the business and has net income in subsequent years to use the carryovers.)
There are several special requirements and rules for the home office deduction. A home office must be exclusively and regularly used for business, meaning children and guests can’t use this room. Report “indirect expenses” on Form 8829 and include every expense and cost related to the home. For example, include depreciation or rent, utilities, insurance, repairs and maintenance, security, cleaning, lawn care, and more.
Include mortgage interest and real property taxes, too, and this home-office portion doesn’t require income. The remaining part of mortgage interest expense and real property taxes are Schedule A itemized deductions.
Real property taxes on Schedule A are part of the new tax law (TCJA) SALT limitation. However, the home office portion or real property tax is not subject to the SALT limitation.
To calculate the home-office deduction, take the square footage of the home office (and all related business areas such as storage, hallways, and bathrooms). Divide that by the total square footage of the home (10-15% is customary). Alternatively, taxpayers can do the apportionment based on the room’s method. Form 8829 multiplies the home-office percentage by the indirect expenses. If the business files a partnership return, report home-office expenses as unreimbursed partnership expenses (UPE) on Schedule E. For S-Corps, use an accountable reimbursement plan before year-end.
Per Thomson Reuters/Tax & Accounting Client Letter (see list below):
Sales of homes with home offices. If you sell-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 won’t apply to the portion of your profit equal to the amount of depreciation you claimed on the home office.”
Depreciation expenses on the home office over the years save taxes at ordinary income tax rates. Recapture of depreciation on a sale of the principal residence is taxed up to a 25% capital gains rate, which is unique to Section 1250 property. Tax deferral is another value. The rest of the home enjoys the exclusion of capital gain up to the limit.
If a taxpayer sells his principal residence at a loss, the net loss is not deductible. However, the recapture of depreciation income might not exceed the loss amount, meaning there is no taxable income from depreciation recapture to report on the tax return.
TCJA capped state and local income taxes, sales taxes, real property taxes, and personal property taxes (SALT) itemized deductions on Schedule A at $10,000 per year (any combination thereof), and $5,000 for married filing separately. TCJA also reduced itemized deduction limits on mortgage interest expenses and casualty losses.
Home office tax benefits for employees
Employers require some employees to work from a home office. The new tax law (TCJA) suspended unreimbursed employee business expenses as itemized deductions. That leaves only one other way to arrange a tax benefit for home office expenses. An employee can seek reimbursement from an employer for home office expenses through an accountable reimbursement plan. The employer deducts home office expenses and does not include this payment on the employee’s W-2 as taxable income.
Our below Thomson Reuters/Tax & Accounting Client Letter for “telecommuting employees” states:
The convenience of the employer requirement is satisfied if: you maintain your home office as a condition of employment-in other words, if your employer specifically requires you to maintain the home office and work there; your home office is necessary for the functioning of your employer’s business; or your home office is necessary to allow you to perform your duties as an employee properly. The convenience of the employer requirement means that you must maintain your home office for your employer’s convenience, and not for your own. This requirement isn’t satisfied if your use of a home office is merely “appropriate and helpful” in doing your job.”
Client Letters from Thomson Reuters/Tax & Accounting:
- Home office expense deduction for a self-employed taxpayer
- Exclusion of gain on sale or exchange of principal residence
- How the home sale exclusion applies to a residence used for residential and business (nonresidential) purposes or to produce rental income
- Office at home for telecommuting employees
- Converting a home into rental property
For access to these Client Letters from Thomson Reuters/Tax & Accounting, please join our email list. We send bulk emails a few times per month and include links to Client Letters.