Simplified home office deduction: when does it benefit taxpayers?

• Author: Hennig, Cherie

Sec. 280A(c) permits self-employed individuals and employees who work out of their home to deduct business expenses relating to the part of their home that is exclusively used on a regular basis to carry on a trade or business, or, in the case of an employee, the person has no other fixed location to perform his or her job duties. Exclusive means just that--the space is never used for a nonbusiness purpose and is regularly used for meeting with clients or customers and/or performing administrative and management activities.

If an employee works at home for his or her convenience rather than for the employer's convenience, the deduction is not allowed.' In limited circumstances, primarily when the home is the sole, fixed location of the trade or business, space used to store inventory or product samples may also be counted as business use.' It is also important to note that certain day care providers may take a limited deduction even when the space does not meet the exclusive use requirement.3 Starting with the 2013 tax year, the IRS is offering a safe--harbor alternative to the home office deduction individual taxpayers can claim.' Traditionally, the Sec. 280A home office deduction requires complex computations and allocations and burdensome recordkeeping. The new alternative is a simplified method in which the taxpayer multiplies the total square footage of the business portion of the personal residence by $5. What could be simpler than multiplying the length and width of the office space to get the total square footage of the business portion of the home? But before deciding to use the simplified method, its costs and benefits should be evaluated. While many taxpayers will adopt this new method in the interests of simplicity, there are certain instances, discussed later, where simple may not be better.

A recent article in The Tax Adviser' provides a detailed history of the home office deduction, describes the actual--cost and safe--harbor methods, and provides several examples comparing the two methods. This article is not intended to repeat that excellent summary, but to provide the results of a sensitivity analysis' of the benefits of the two methods for taking the home office deduction across a range of three variables: the square footage of the home office, the total cost of the residence, and the marginal tax rate. An Excel spreadsheet, available at tinyurl.com/nqcd5pq, illustrates this analysis. First, a simple example demonstrates the basic computations of the home office deduction using both actual costs and the safe--harbor method, followed by a sensitivity analysis and summary of results. Finally, the key factors to consider when electing the safe--harbor method are discussed.

Comparing the Two Deduction Methods: An Example

Example 1: A has net income from her business before the home office deduction of $5,600. She purchased her residence for $100,000, excluding the cost of the land, has a home office of 350 square feet (10% of the house's total square footage of 3,500) and has a marginal tax rate of 15%. She paid $10,000 in mortgage interest and $3,000 in real estate taxes. The total indirect costs of operating the residence (utilities, insurance, and repairs and maintenance) are $4,800. The depreciation expense on the business portion of the residence is $256. The total deductions under each method are provided in Exhibit 1.

Exhibit 1: Comparison of the actual-cost home office deduction and the simplified method Actual-cost method Tier I deductions $1,300 Tier II deductions 480 Tier III deductions 256 Total home office deduction $2,036 Simplified method Maximum square feet 300 x $5 $1,500 Increase in itemized deductions $1,300 Total deduction $2,800 Net benefit of simplified method $764 Actual--Cost Deduction:

Observations

The home office actual--cost deduction has three components, as defined in...