Clarifying the Business Use of Home Deduction
What are the Tax Implications of WFH?
Over the course of the last 18 months, working from home has become commonplace in many industries, whether due to state and local mandate or personal preference. The paradigm has undoubtedly shifted over the course of the pandemic for many businesses, and this trend will continue moving forward. With changes in work arrangements, it’s worthwhile to discuss tax implications related to use of personal home for business use. The Business Use of Home tax provision has been tax law for many years, but with recent law and environment changes the finer details may be unclear.
What is considered home office space?
To be eligible for the home office deduction, the home office must be used exclusively and on a regular basis. This means that the area used for business must be a “separately identifiable space”. This interpretation allows for nearly any space in the home to be considered a principal place of business, but the IRS is strict in its view of “exclusive use” of the space. Any indication of the area used for dual personal use can cause the deduction to be disallowed.
Who is allowed a home office deduction?
A deduction for home office use is allowable to a business if it meets any of the following:
- The principal place of business;
- A place to meet patients, clients, or customers in the normal course of business;
- A separate structure not attached to the dwelling and used in connection with the business; or
- A space used regularly to store the business’s inventory or product samples.
Understanding that the home office deduction is a business expense means that those who are eligible own and operate a business with gross receipts and other business expenses. Business entities that file IRS form Schedule C and F are the most common eligible to take the deduction. Owners of partnership interests are also eligible to deduct home office expense use expenses as unreimbursed partner expenses if the partnership agreement expressly states that the partner is required to incur the expenses personally. Some special facts and circumstance instances can make the deduction eligible for Schedule E filers as well. There are additional special rules that pertain to the use of home for daycare service providers.
Who is disallowed from the home office deduction?
Prior to the Tax Cuts and Jobs Act (TCJA) of 2017, unreimbursed employee expenses were allowed as a miscellaneous itemized deduction, subject to AGI limits. This was the only opportunity for employees compensated via W2 pay to deduct qualified home office expenses paid for the benefit of the business. Miscellaneous itemized deductions were suspended until 2026 with the passage of the 2017 Act, and no action has been made to reinstate the deduction any earlier. Owner employees of S Corporations are included in those not eligible for the home office deduction by means of their compensation as an employee of the business. To still allow for tax deductibility of these unreimbursed expenses, S Corporation owners can look to establish an accountable plan to reimburse home office items.
How to calculate a home office deduction?
There are two methods available to calculate the potential deduction:
- The Actual Expense Method
- Simplified Method
A taxpayer is entitled to the greater of the two calculations for the tax year and may alternate methods from year to year.
The Actual Expense Method allows the taxpayer to substantiate and deduct direct and indirect actual expenses incurred for the business portion of the home, including the ability to take a depreciation deduction for that part. This causes additional complexities when the house is ever sold in the future, however, the Simplified Method provides a prescribed rate of $5.00 per square foot of the business portion of the home, up to a maximum of 300 square feet. This method allows taxpayers to avoid additional record keeping and calculations to figure the actual expenses. Home office expense deductions are limited to the gross income earned by the business. Any amounts unused in the Actual Expense Method for the current year can be carried to the subsequent year where they will again be subject to gross income tests. The Simplified Method does not provide for carryover of unused amounts.
Selecting the optimal method and calculating the allowed business use of home amount is situational and requires a look at several facts and circumstances. Consult your Adams Brown advisor for further information regarding Business Use of Home deductions.