New Simplified Method Available for Home Office Deductions / Many taxpayers in some fashion use a portion of their home for business purposes

Lane Keeter, CPA for the SunTimes writes: Many taxpayers in some fashion use a portion of their home for business purposes. Under certain conditions, such use of the home can lead to valuable tax deductions against business income.

The recordkeeping and calculation of these deductions can be burdensome and confusing, causing some to forego taking the deduction to which they are otherwise entitled.

To help with this, the IRS has issued an optional "simplified safe harbor" deduction method that can be used in lieu of deducting actual expenses.

As background, the tax code allows as a business deduction the direct expenses and the business-use part of the indirect expenses relating to business use of a home if one of the following strict conditions are met:

(1) Part of the home is used regularly and exclusively as (A) a principal place of business, or (B) a place to meet or deal with customers or clients in the ordinary course of business. Employees must meet an additional test; the use of their home office must be for the convenience of the employer.

(2) Expenses that are allocable to space within the home used on a regular basis for the storage of inventory or product samples held for use in the taxpayer's trade or business of selling products at retail or wholesale are deductible if the dwelling unit is the sole fixed location of the trade or business.

(3) Expenses that are attributable to the rental of the home or a part thereof are deductible.

(4) Expenses that are allocable to the part of the home used on a regular basis in the taxpayer's trade or business of providing day care for children, for individuals who have attained age 65, or for individuals who are physically or mentally incapable of caring for themselves are deductible.

Once you determine if you qualify, fairly complex expense allocations have to be made based on the amount of the home used for business versus the home's total size, and an overall limit is placed on the deductions based on the activity's gross income reduced by all other deductible expenses that are allowable regardless of qualified use (e.g., mortgage interest, real estate taxes, and casualty losses) and by the business deductions that aren't allocable to the use of the home itself (e.g., expenses of advertising, wages, and supplies).

Expenses disallowed solely because they exceed business income can be carried forward to future years.

To reduce the burdens of determining the allowable deduction for the qualified business use of a home, the IRS now has a safe harbor method under which an individual determines his allowable deduction for the qualified business use of a home by multiplying a prescribed rate ($5) by the square footage of the part of his residence that is used for business purposes, not to exceed 300 square feet.  Thus, the maximum deduction under the safe harbor is $1,500.

"Qualified business use" for this purpose is business use that satisfies the four requirements already discussed above.

If an employee, the safe harbor method doesn't apply if you receive advances, allowances, or reimbursements for expenses related to the qualified business use of the employee's home under a reimbursement or other expense allowance arrangement with your employer.

The safe harbor is an alternative to deducting actual expenses. So if it's used for a particular tax year, you generally cannot deduct any actual expenses related to the qualified business use of that home for that tax year except for:

(1) Home-related deductions that would be allowed as itemized deductions, business use or not, such as mortgage interest, property taxes and casualty losses, and

(2) Normal business deductions not related to qualified home use such as advertising, wages, supplies, etc.

A taxpayer using the safe harbor for a tax year also can't deduct any depreciation for the part of his home that is used in a qualified business use for that tax year. However, if a switch is made to actual expenses in a later year, which is allowed, depreciation may be taken in that later year.

There are other nuances of using the safe harbor that are beyond the scope of this article. The IRS has revised Publication 587 to provide insight into these nuances, as well as details and examples of how make the calculation.

In general, my hunch is that using the safe harbor will result in a lower tax deduction than will using actual expenses in most cases. So make sure you have a thorough understanding of the issues involved and what your options are before making the decision to use the safe harbor method.