A home office must qualify as your principal place of business. This means it must be used:
(1) exclusively and regularly for administrative or management activities of your business or
(2) you have no other fixed location where you conduct substantial administrative or management activities of your trade or business. Examples of administrative or management activities are:
[IRS Instructions for Form 8829, “Expenses for business use of your home”].
● Billing customers and clients.
● Keeping books and records.
● Ordering supplies.
● Setting up appointments.
● Forwarding orders.
● Writing reports.
In determining whether a home office qualifies as a principal place of business you must consider the relative importance of the activities at each place you conduct business and the amount of time spent at each place you conduct business.
Employers may give employees the option of performing some of their responsibilities at home. But just because the employee finds it convenient to work at home, that does not mean that the deduction will be allowed. To be able to claim a home office deduction, the employee must show the home office is for the “convenience of their employer”. This usually is interpreted by the IRS to mean that the employer must require the employee to work at home or the employer does not provide an office where the employee can work. If the employee requires telecommuting and the employer has on-premises office space available, the IRS is likely to argue that the home office is for the convenience of the employee not the employer [J.K. Lasser’s Your Income Tax, 2013].
The deductions, other than mortgage interest and property taxes, are reported on Schedule A as a miscellaneous itemized deduction, subject to the 2% of AGI floor. Mortgage interest and property taxes are reported on Schedule A under their respective categories.
If the taxpayer is a sole proprietor, the expenses are deducted on Form 8829, “Expenses for business use of your home” and then transferred to , Schedule C, line 30. [NOTE: form 8829 is shown in the taxconnections.com library]. If the taxpayer is a C or S corporation, they are taken on the corporate return. The home office expenses can NOT exceed the net income from self-employment. Any unused amounts can be carried over to future years but can’t be deducted if the standard deduction is used (see discussion and examples below for standard deduction and priority of deductions when home office expenses exceed net income from self-employment).
If you operate a business from your home, using a room or other space as an office or area to assemble or prepare items for sale, examples of allowable expenses are utilities, painting, repairs and maintenance, insurance, rent, mortgage interest, property taxes, casualty loss, and depreciation. These expenses are divided into to three categories: (1) directly attributable to the home office, (2) indirectly attributable to or that benefit the home office (these would be expenses incurred for the entire house and allocated to the home office, such as utilities, insurance, rent, mortgage interest, property taxes, security system, casualty loss) and (3) depreciation of the house allocated to the home office. Costs of landscaping and lawn care are not deductible. If a security system is installed for all your home’s doors and windows, the portion of the monthly maintenance fee must be allocated to the home office as an indirect expense. The cost of the system must be depreciated using MACRS over five years and allocated to the home office as an indirect expense (See discussion below on allocation of indirect expenses).
To deduct home office expenses, you must prove that you use your home area exclusively and on a regular basis either as:
(1) a place of business to meet or deal with patients, clients ,or customers in the normal course of business. Incidental or occasional meetings do not qualify.
(2) your principal place of business. This means you spend most of your working time there and most of your business income is derived from the activities conducted in your home office.
A self-employed taxpayer may have administrative or management activities performed at locations other than their home. The following will NOT disqualify your home office from being used as your principal place of business [IRS Instructions for form 8829, “Expenses for business use of your home”].
● another company does your billing.
● car or hotel room.
● You conduct minimal administrative or management activities at a fixed location outside your home.
● You conduct substantial nonadministrative or management activities at a fixed location of business outside your home, e.,g., meeting with clients or customers at a restaurant.
You can also deduct expenses that apply to space within your home used on a regular basis to store inventory or product samples from your trade or business or selling products. In this case, your home must be the only fixed location of your trade or business. The space must be separately identifiable and suitable for storage [IRS Instructions for form 8829, “Expenses for business use of your home”].
Allocation of Indirect Expenses
These are allocated based on the ratio of the amount of square feet occupied by the home office to the total square footage of the house. The basis for depreciation is the lesser of the fair market value at the time you started your home business or its adjusted basis ,excluding the land cost. The house is depreciated on a straight-line basis using MACRS over 39 years. You can only deduct depreciation on the portion used for the home office [J.K. Lasser’s Your Income Tax, 2013].
In April 2010, David purchased a house for $195,500 excluding the value of the land, and uses one room exclusively for a home office where he operates a tax service and meets with clients. The total square footage of the house is 2,500 and his office is 500 square feet. In 2013, he paid the following expenses:
Tier 1 direct: painting office $250 repairs $450, cleaning service $600, Total $1,300.
Tier 2 indirect (incurred for entire house): mortgage interest $6,250, real estate taxes $3,550, utilities $3,200, home owners insurance $850, security system monitoring fees $900, depreciation of security system $310.
Allocation home office 500 square feet of home office divided by square feet of entire house = 20%:
The remaining mortgage interest and property taxes are taken as an itemized deduction on Schedule A.
Tier 3 depreciation: entire house $5,010. Allocated to home office $1,000.
Priority of deductions subject to the overall limitation
Example 1: net income exceeds all home office expenses.
Net income before home office expenses is $7,500. All the home office expenses are allowable because the $5,312 total ($1,300 + $3012 + $1,000) are less than net income before home office expenses. Net income after home office expenses is $2,188 ($7,500 – $5,312).
Example 2: net income exceeds only tier 1 expenses.
Net income before home office expenses is $3,800. All tier 1 expenses are allowed. Tier 2 expenses are limited to $2,500 ($3,800 net income before home office expenses , less $1,300 tier 1 expenses). The remaining $512 ($3,012 – $2,500) tier 2 expenses and depreciation are not allowable but can be carried over to 2014. Net income after home office expenses is zero.
Example 3: net income exceeds tier 1 and tier II expenses.
Net income before home office expenses is $4,500. All Tier 1 and Tier II expenses are allowable because they are less than net income before home office expenses. Depreciation is limited to $188 ($4,500 net income before home office expenses, less $4,312 tier 1 and tier 2 expenses. Depreciation is the last home office expense considered in determining the allowable expenses. The disallowed depreciation can be carried over to 2014. Net income after home office expenses is zero.
Standard deduction in lieu of actual expenses
Starting in 2013, the IRS allows a standard deduction in lieu of actual expenses. The amount is $5.00 per square foot (maximum 300 square feet- $1,500). The amount is reported on Schedule C, line 30. Like actual expenses, the standard deduction cannot exceed net income before home office expenses. Unlike actual expenses, if the standard deduction exceeds net income, the excess can not be carried over to future years. The standard or actual deduction is elected on an annual basis and whichever method gives the larger deduction should be used, assuming you have proper substantiation for actual expenses. The advantage of the standard deduction is that the IRS will not question it, although they could ask for documentation of the square footage of the home office. If you have more than one business being operated in the same home, there is only ONE standard deduction which must be allocated to EACH business on the basis of square footage (maximum $1,500 for ALL home offices). If you have a carryover of actual expenses from a prior year, they can NOT be used in a year in which the standard deduction is claimed.
Example 1. business net income exceeds standard deduction.
(A) Joe’s home office is 250 square feet and his net income before the home office deduction is $5,100 . He elected to use the standard deduction in lieu of actual expenses. Joe’s home office deduction is $1,250 ($5 x 250). Net income after home office expenses is $1,199 ($5,100 – $1,250).
(B) Joe’s home office has 400 square feet. Even though the amount for his home office based on $5 per square feet is $2,000, Joe’s standard deduction cannot exceed $1,500. Net income after home office expenses is $3,600 ($5,100 – $1,500).
Example 2. business net income is less than the standard deduction.
Assume the same facts in (B) above, except net income before the home office deduction is $1,300. Even though the normal standard deduction is $1,500, his deduction is limited to $1,300 net income before the home office deduction. The $230 excess can not be carried over to 2014. Net income after the home office expenses is zero.
[J.K. Lasser’s Your Income Tax, 2013]
Investors who manage their own securities portfolios are not likely to prevail in court if a home office deduction for investment management as a business activity is disallowed by the IRS. The House Ways and Means and Senate Finance committees reports state that a deduction should be disallowed for a home office to read financial periodicals and reports and perform other investment management related activities. The Court of Claims, in Moller allowed a deduction for an investor who spent 40 hours a week on management of a substantial portfolio, but an appellate court reversed the Court of Claims stating:
The test is whether or not the person is a trader. A trader is in a business; an investor is not. A trader buys and sells frequently to catch daily market swings. An investor buys securities for capital appreciation and income without regard to daily market developments. Therefore, to be a trader, one’s activities must be directed to short-term trading, not the long-term holding of investments.
Moller was an investor primarily interested in long-term growth potential of his securities and did not earn income from the short-term turnover of his investments. He did not have significant trading profits-dividend and interest income was 98% of his income.
An investor’s interest and dividend income is reported on Schedule B. Capital gains and losses are reported on Form 8829 and totals are transferred to Schedule D. Expenses (margin interest can’t exceed net investment income) are taken as a miscellaneous itemized deduction reduced by 2% of AGI. A trader’s income from interest and dividend income is reported on Schedule C. Capital gains and losses are reported on Form 8829 and totals are transferred to Schedule C. Expenses are deductible against income on Schedule C.
Day Care Center
The exclusive-use test does not have to be met to provide day care services for children and handicapped persons, or anyone age 65 and older provided state licensing requirements are met. If part of your home is used regularly but not exclusively to provide daycare, the expenses are deductible. If the home is used regularly but not exclusively for daycare, an allocable part of indirect expenses can be deducted.
To be able to deduct home office expenses for a day care center, you must have applied for (and not been rejected) been granted (and still have in effect) or be exempt from having a license, certification, registration, or approval as a day care center or as a family or group daycare home under state law [J.K. Lasser’s Your Income Tax, 2013].
Determining daycare business use percentage (Part I, form 8829):
1. Divide the square feet used for daycare by the total square feet of the house, and enter on line 3.
2. Divide the total hours during the year used for daycare by 8,760 (total hours available for a year) and enter on line 6.
3. If the home is used exclusively for day care enter on line 7, the decimal from 2 above.
4. If the home is not used exclusively for day care, multiply the decimal from 2 above by the percentage from 1 above, and enter as a percentage on line 7.
If you stopped using the home during the year as a day care center, you must prorate the number of hours based on the number of hours the home was available for daycare. These hours are used instead of 8,760 for 2 above.
Example-computing percentage of house used for daycare
During 2013, Charlotte operated a daycare center in her home from 7 a.m. to 6 p.m. five days a week for 50 weeks (2,750 business hours). The daycare portion occupies 2,000 square feet and the total house is 3,000 square feet. Based on the steps above, the applicable amounts are:
(1) 2,000 square feet for day care divided by 3,000 total house square feet = .6667 (66 .67%.)
(2) 2,750 hours used for day care divided by 8,760 total hours for the year = .3139 (31.39%)
(3) Since the home is not used exclusively for day care, the percentage used to allocate indirect expenses for the entire house to the day care portion is 21% (66.67% x 31.39%)
[Indirect expenses for the entire house are allocated to the daycare portion using 21%, the percent computed in (3) above. The limitations and priority of deductible expenses are the same as the methods used for a home office for a self employed person. [NOTE: Form 8829 can be downloaded from my TaxConnections Tax Library – HERE].