The COVID pandemic forced many of us home for at least part of the year, resulting in our homes functioning as schools, day care facilities, and, yes, offices. With this shift – whether it is temporary or it will become the new norm – you may be wondering if you are entitled to a nice tax break in the form of the Home Office Deduction. If you are an employee, the short answer is No. The Tax Cuts and Jobs Act (TCJA) of 2017 suspended the Home Office Deduction for employees for tax years 2018 through 2025. Therefore, the remainder of this article will focus on self-employed individuals.
In general, expenses associated with a “dwelling unit” used by a taxpayer as a residence are disallowed unless a specific exception applies. As one exception to the general rule, a taxpayer is permitted to deduct expenses for the business use of a home. Now, you may be wondering if “working from home” is akin to “business use of a home.” The answer – maybe.
If you are self-employed, we need to look at the specific requirements in the Code to determine whether you qualify for the deduction. Expenses may be deductible if the home is used regularly and exclusively (1) as the principal place of business, (2) as a place for meeting or dealing with patients, clients, or customers for business purposes, or (3) in connection with a business if the office is a separate structure that is not attached to the home. These three rules require regular and exclusive use for the space to qualify as a “home office,” so some definitions are in order.
To qualify as regular use, the specific area must be used for business purposes on a regular basis (I know – thank you Captain Obvious). The proposed regulations are not very helpful with this determination – they provide that whether the taxpayer’s use is “regular” depends on “all the facts and circumstances.” If we look to case law, regular use is probably achieved with frequent and repetitive use, and occasional or incidental business use likely does not meet the standard.
To qualify as exclusive use, a specific area in your home must be used only for your business. It does not qualify if used for both personal and business purposes. The area does not need to be a specific room (i.e., marked off by a permanent partition); it can be a specifically identifiable space within a room (e.g., a desk in the corner of a room).
Principal Place of Business
Okay, so your use is regular and exclusive, but is your home office the “principal place of business?” If you have no other business location, the answer is easy, but what if you have multiple business locations (i.e., you have a separate office and you work out of your home)? Under the rules, two alternative standards are available to determine which location is the principal place of business.
First, if the home office is used regularly and exclusively for administrative or management activities, and there is no other location where such activities are conducted, it qualifies as the principal place of business. The Service has identified the following as examples of administrative or management activities: billing customers, clients, or patients; keeping books and records; ordering supplies; setting up appointments; and forwarding orders or writing reports. This is huge – even if you have a business location outside the home, you may qualify for the Home Office Deduction if the business is managed from the home.
Alternatively, the principal place of business determination may be made based on the relative importance of the activities performed at each location and the time spent at each location. In evaluating the relative importance of the activities performed, the location at which services are rendered or goods are delivered is a principal consideration. If comparing the activities performed at each location does not yield a definitive conclusion, the time spent at each location may be used. In 2020, the relative importance of activities performed and time spent at home may have drastically increased, thus making your home the principal place of business this year when it may have not been in the past.
Place for Meeting or Dealing with Patients, Clients, or Customers
If your home office does not qualify as the principal place of business, you may still be able to claim the Home Office Deduction under the “meeting or dealing” exception. Again, the business use of your home office must be regular and exclusive, and if your meetings or dealings with patients, clients, or customers in your home office are more than occasional and are substantial and integral to the conduct of your business, you may qualify for the Home Office Deduction. Importantly, this exception only applies if your patients, clients, and customers physically visit your home – phone calls and video conferences do not qualify.
Separate Structure Not Attached to Dwelling Unit
If all else fails, you may still be able to claim the Home Office Deduction if the office is a separate structure from, and not attached to, your home and you use it regularly and exclusively for business purposes. Examples include a free-standing studio, garage, or barn.
Limitations and Eligible Expenses
If, based on the rules articulated above, you have a qualifying home office, you may be able to deduct expenses for the business use of your home, subject to certain limitations (there are ALWAYS limitations). The Home Office Deduction is subject to a gross income limitation, meaning that the deductions for the home expenses cannot be used to create a net loss for the business activity. There are two methods available to calculate the Home Office Deduction – the Regular Method and the Simplified Option. The Simplified Option involves simply multiplying the allowable square footage of the home office (up to a maximum of 300 square feet) by a prescribed rate ($5.00) to determine the deduction (capped at $1,500). Under the Regular Method, actual expenses must be allocated between the personal use portion of the home and the business use portion of the home. Common methods of allocation include square footage or number of rooms. Allocable expenses include real estate taxes, home mortgage interest, depreciation, insurance, utilities, repairs, and rent paid in the case that you do not own the home.
Due to the COVID pandemic, we are using our homes for business purposes more than ever before. If you think you may now qualify for the Home Office Deduction, or have questions regarding your personal tax situation, please contact your HBK representative or a member of our Tax Advisory Group to discuss further.