The IRS announced (Rev. Proc. 2013-13) a safe harbor method that individual taxpayers have the option of using to determine the amount of deductible expenses attributable to certain business use of a personal residence. The safe harbor method is effective for taxable years beginning in 2013. The IRS has stated that the current computation of the home office deduction is complex and is hoping that the safe harbor method will reduce taxpayer compliance.
The requirements that the taxpayer must use the home office exclusively and on a regular basis as the taxpayer’s principal place of business or as a place to meet with the taxpayer’s patients/customers/clients remain unchanged. Likewise, if an employee deducts a home office expense, the IRS requirement that the home office is required by the employer for the convenience of the employer remains a requirement.
The taxpayer computes the home office deduction by multiplying the prescribed rate of $5.00 by the square footage of the portion of the taxpayer’s residence (owned or leased) that is used for business purposes (such square footage cannot exceed 300 square feet). Thus the maximum home office safe harbor deduction is limited to $1,500. If the safe harbor method is used, then no actual expenses can be considered.
The safe harbor method cannot be used if the employee receives any reimbursement or other expense allowance from the employee’s employer. Once the election is made for a particular tax year, it is an irrevocable election for that one tax year. It cannot be changed by filing an amended tax return. However, the taxpayer is not bound to use the actual or safe harbor computational method in any following tax year and can switch between methods if the taxpayer so chooses.
If the safe harbor election is made, the taxpayer is required to deduct 100% of mortgage interest and real estate taxes paid as an itemized deduction on Schedule A. The taxpayer is not allowed to deduct any depreciation expense if the safe harbor method is used. If the taxpayer switches from the safe harbor to actual expenses in a subsequent year, the taxpayer will be required to compute the depreciation expense using an optional depreciation table and methodology in the subsequent year.
If actual expenses are used and the taxpayer is limited by IRS thresholds, the taxpayer can carry those unused deductions forward to subsequent tax years. If the safe harbor method is used, any unused losses cannot be carried forward and are lost. If the taxpayer had unused expenses from a year that actual expenses were used and elects the safe harbor in a subsequent year, those unused expenses cannot be deducted in the year that the safe harbor is used but may be used if the taxpayer elects the actual methodology in any subsequent year.
There are also special rules for determining the 300 square feet of home office in a year when the taxpayer has not used the home office the entire tax year.
The optional method will likely appeal to taxpayers who like simplicity, who believe that using the optional method may decrease the risk of an IRS audit, are not overly concerned about maximizing the home office deduction, and hope that this method will reduce their tax preparation fees. Taxpayers using the actual method will be those who maintain substantive documentation and are not concerned about an IRS audit, realize that allocating a portion of the mortgage interest and real estate taxes to the home office help reduce self-employment taxes and thus the overall taxes paid to the IRS, and do not wish to lose the ability to carryforward unused losses. For those taxpayers who switch methods between years, any incremental tax savings would likely be offset by increased tax preparation compliance costs.
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