Should I Use the Simplified Home Office Deduction?
Many home-based businesses will be able to benefit from a new, simplified method of claiming the home office deduction, starting with the 2013 tax returns. You can claim a deduction of up to $1,500 using the simplified form, provided you meet the stringent regular and exclusive use requirements. However, make sure you don't put convenience ahead of tax savings.
For those who meet the requirements, the home office deduction can be a tax-saver. Yet, the hassle of filing out the 43-line form with its complex calculations to allocate expenses, depreciation and carryovers of unused deductions is so daunting that many people don't bother. In response to this complexity, the IRS provided a simplified method of claiming the deduction, beginning in 2013
Can You Claim a Home Office Deduction?
In order to use the simplified method, you first must meet the qualification requirements for the home office deduction. These are strict—and you will be held to a standard that an employee working in the employer's office is not required to meet. There are three core conditions for claiming any amount as a deduction:
- Exclusive use. Your home office must be used exclusively for business purposes. There are limited exceptions for day care providers and for inventory storage, but if those don't apply, even the slightest bit of non-business use by you or anyone else will cost you the right to the deduction.
- Regular use. Making use of the space "every so often" will not satisfy this test.
- Business use. The space must be your principal place of business or used for face-to-face meetings with customers or clients on a regular basis. Principle place of business doesn't necessarily mean the only place of business, provided there is no other fixed location where you conduct substantial administrative or management activities for your business.
What Is the Simplified Method?
For once, what the IRS calls simplified actually lives up to its name—at least in terms of computing the deduction. To determine your home office deduction under this method, you multiply the 'allowable square footage' for your home office by 'the prescribed rate.'
The allowable square footage is the lesser of:
- The actual square footage of your home office or
- 300 square feet.
The prescribed rate $5 per square foot. (The IRS says it will update this rate from time-to-time when it feels it is necessary to do so.)
The maximum deduction that can be claimed using this method is $1,500. However, you can't claim more than your gross income of your business that is attributable to the business use of your home minus any business deductions that are unrelated to the use of your home (such as business equipment and supplies). And, any amount that is disallowed because of this income limitation is lost—it cannot be carried over to offset income in another tax year.
You make the election to use the simplified method by simply using it when you file your tax return. Bear in mind, once you elect to use it (or not use it) you cannot change your mind for that tax year. You can, however, elect to use whichever method you wish on a year-by-year basis.
Should You Use the Simplified Method?
As you probably learned the hard way while growing up, just because you can do something, doesn't mean you should. In this case, there are a number of situations where simple might not be better. Although time is money, money is also money and you don't want to hand Uncle Sam any more of yours than you legally must.
If any of these apply to you, then you will want to check both options for this year, and then be alert for changes that could affect your decision is future years.
- You rent, rather than own—particularly if you live in a high rent area
- You pay a significant amount of mortgage interest or real property taxes
- You have high utility costs attributable to the business use of your home
- You have home office deduction carryovers from prior years
- You have very little income this tax year
- You didn't use your home for business for the full year
- You foresee switching between the two methods
Let's explore each of these in more detail.
You rent, rather than own. The home office deduction is often of greatest value to renters. The 'big ticket' deductions that are rolled into the home office deduction are mortgage interest and property taxes. A homeowner can claim these deductions regardless of whether he or she claims a home office deduction—the difference is where and how they are claimed, not whether they are deductible. But, a renter has no way to recoup rental costs, absent a home office deduction. Therefore, if you rent, you will definitely want to do a quick computation using the regular method and the simplified method. This is especially true if you are living in a high-rent area, such as New York, San Francisco, or Washington, D.C.
The home office deduction is based on the percentage of space used for the home office: All the expenses are allocated to the home office based on this percentage. There are two standard methods of computing this percentage: square foot and number of rooms method. Using the square foot method, the square footage of the space used regularly and exclusively for business is divided by the total square footage of your home. Using the number of rooms method, the number of rooms used for your home office is divided by the total number of rooms in the home.
Many times one of these methods will result in a much larger deduction. And, either of them is likely to yield a larger deduction that the simplified method.
Raymond uses one bedroom of his two bedroom Washington, D.C., apartment as the principal office of his software development business. The home office is 100 square feet. The total square footage of his four-room apartment is 556 square feet. His monthly rent (which includes utilities) is $1,800/month.
Using the regular square foot method, he can deduct 18 percent of his rent (100/556). With this method, his deduction is $324/month or $3,888 per year.
Using the regular percent method, he can deduct 25 percent of his rent (1/4). So, his monthly deduction would be $450/month or $5,400/year.
Either of these methods would give Raymond a substantially higher deduction than the $1,500 he could claim using the simplified method.
Your mortgage and taxes are high. As noted above, homeowners can deduct their mortgage interest and property taxes regardless of whether they claim a home office deduction. However, without the home office deduction, these are claimed on Schedule A as itemized deductions that offset your adjusted gross income. In contrast, mortgage interest and taxes claimed as part of the home office deduction is used to directly reduce your income from your business. This, in turn, can lower your adjusted gross income and increase your tax savings.
Lowering your adjusted gross income can be an exceptionally important strategy if you are near the threshold for the new 3.8 percent Medicare tax on net investment income. Similarly, if you are bumping up against the 0.9 percent Medicare surtax on earnings, lowering your net earnings from your business can save you taxes on multiple fronts.
Your home-related expenses are high. Some businesses involve increased utility costs, such as the cost of specialty lighting. Some require additional homeowner's insurance coverage. For example, if clients regularly come to your home, you will probably want to increase your insurance to protect you if they slip and fall on black ice on your driveway. Other businesses may require you to make alterations to the existing space, such as installing display cases or partitions. If you use the regular method of determining the home office deduction, some—if not all—of these increased costs can be deducted. You do not have this option if you use the simplified method.
Your business income is low. Regardless of the method used—simplified or regular—your home office deduction for any year is capped at the amount of your income from your home-based business. However, if you use the regular method, you can carryover the amount that you cannot use to subsequent tax years. If you use the simplified method, you simply lose the value of the deduction.
Liz's net income from her fledgling home-based craft business is $1,000. Using the simplified method, her maximum home office deduction would be $1,400. Because she cannot claim more than her income, $400 worth of deductible expenses are lost.
If she spends the time to struggle through the regular method, any amount that she can't claim on her return can be carried over to offset income in the next year (assuming she opts for the regular method in that year as well.)
You weren't in business all year. If you didn't use your home for business for twelve full months, you are going to have to prorate your square footage, which will reduce your maximum deduction. In order to count as a month of use, you must use your home office for at least 15 days out of each month.
On June 19, Anne begins using 100 square feet of her home for her consulting business. She continues to use her home office for the remainder of the year. If she uses the simplified method to determine her deduction, she cannot simply multiply 100 times $5. Instead, she must prorate the square footage as follows:
She used the space for six months. (June does not count because she did not meet the 15-day requirement)
She multiples the square footage (100 sq. ft) by the month used (6) and divides by 12, resulting in a prorated square footage of 50 square feet.
The prorated square footage (50) is multiplied by the prescribed rate ($5) to arrive at a maximum deduction of $250.
Anne would be wise to explore the regular method to see if it provides her with a higher deduction.
You foresee switching methods. One of the blessings—and curses—of the simplified method is that you do not have to worry about determining the amount of depreciation on the business portion of the home. If you use the simplified method, the amount of depreciation is defined to be zero. This means that you not only avoid computing it, you avoid having to recapture it when you sell your house.
If you use the regular method to compute the home office deduction and you don't claim the appropriate amount of depreciation, you will hurt yourself in both the short and long-term. Short-term, you'll have a smaller annual deduction. Long-term, the IRS will demand that you recapture the amount of depreciation that you should have claimed.
As long as you keep using the simplified method, the rule regarding depreciation will not cause you any grief. If you have significant depreciable improvements to your property, you may lose some tax benefits by not using the regular method, but for most homeowners, that is not likely to be an issue.
However, if you switch between the methods, you (or most likely your accountant) will have to deal with a series of recomputations, using special tables. While this shouldn't be the sole determination for whether you opt for the simplified method, it certainly is one consideration.