The New Safe Harbor Home Office Standard Deduction

Editor's Note: This article is part of our 2014 Tax Tips series. Robert Flach is an expert with more than 40 years of experience as a tax professional and also blogs as The Wandering Tax Pro.

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NEW YORK (MainStreet) — As part its efforts to reduce paperwork burden, the Internal Revenue Service has created a new simple "safe harbor" option for calculating the home office tax deduction, which is effective with tax year 2013.

This new safe harbor option allows taxpayers with a qualified home office to deduct $5.00 per square foot, up to a maximum of $1,500 (so the maximum allowable area of the home office is 300 square feet), instead of claiming actual expenses.

Normally one would determine the square footage of the home office and divide it by the total square footage of the entire home to come up with a business use percentage. The total costs of the home – real estate taxes; mortgage interest on money borrowed to build, buy or substantially improve the home; homeowners and flood insurance; gas and electric; heating oil; water; garbage collection; alarm system, etc. – are added up and multiplied by this business use percentage. Depreciation is also allowed on the home office area.

This new safe harbor deduction is an option – not a requirement. It is similar to the standard mileage allowance, which can be claimed instead of the business use percentage of the actual costs of operating a car. However the choice is less restrictive than that of electing to use the standard mileage allowance. You can switch from the safe harbor method to actual expenses from year to year.

This new option does not simplify the calculation of the home office deduction. It actually makes it more complicated by adding another step to the process. As I pointed out in an earlier tax tip, when you are faced with options you should review each option and do separate tax calculations to see which one will result in the lowest overall tax. You must calculate the home office deduction under the "normal" method, using actual expenses and compare this to what you are allowed under the "safe harbor" method.

The safe harbor deduction does not include the business use percentage of real estate taxes and mortgage interest. If you use the safe harbor method, you would deduct 100% of mortgage interest and real estate taxes on Schedule A.

For a self-employed taxpayer filing a Schedule C, the safe harbor home office deduction cannot exceed the net income, after expenses, of the business activity. This is also true of the deduction for actual expenses, with one exception.

There is a hierarchy of deductions when the actual expense method is calculated on IRS Form 8829. First you deduct the business use percentage of real estate taxes and mortgage interest. If there is any net business income left over after deducting the appropriate amount of taxes and interest, you can deduct the business use percentage of "other expenses," such as insurance, utilities, security, etc., up to the remaining net business income. If there is still net income left after deducting "other expenses" you can claim depreciation, again up to the remaining net business income.

A Schedule C filer can deduct the business use percentage of real estate taxes and mortgage interest in full, regardless of the net business income. So a home office deduction using actual expenses can create a negative Schedule C.

If the net business income before the home office deduction is $1,000, and the business use percentage of real estate taxes and mortgage interest is $1,500, the Schedule C shows a net loss of $500, which is carried over to Page 1 of Form 1040.

One of the advantages of this is that it moves a portion of the deduction for real estate taxes and mortgage interest from "below the line" to "above the line" and reduces Adjusted Gross Income (AGI). Again as I discussed in an earlier tax tip, there are a multitude of deductions, credits and exclusions that are affected by AGI, and reducing AGI can result in increasing, or allowing, deductions and/or credits, thus reducing tax liability.

When comparing the tax benefit of the two home office deduction options, you must take this into consideration. While the safe harbor method may produce the greater overall tax deduction, using the actual expenses may provide the greater tax benefit due to the reduction of AGI.

There is another disadvantage to the safe harbor deduction when the available deduction exceeds net business income. If you use the safe harbor method, you cannot carry over any disallowed home office deduction to the next year. When a taxpayer claims actual expenses on Form 8829 any of the unused "other expenses" or depreciation, not allowed because they exceed net business income, can be carried over to future years.

You have a bad year in 2013, and your home office deduction is more than your net business income. But you expect substantially increased income in 2014, and the carryover of unused other expenses and depreciation will reduce your income tax, and your self-employment tax, in 2014. You should use actual expenses instead of the safe harbor for 2013.

One advantage of the safe harbor deduction, if it provides the greater overall tax savings, is that it does not include depreciation. In a year when the safe harbor method is used the depreciation deduction allowable for the home office portion of the home for that taxable year is deemed to be 0. So you do not increase the amount of depreciation that must be "recaptured" if you sell the home.

If you elect the safe harbor option and the home office applies to only part of the year, for example you start the business in April, the $5.00 per square foot/$1,500 maximum must be pro-rated based on the number of full months of business use during the year (15 or more days of use = a full month). If you elect to deduct actual expenses you can only include costs incurred when the home office was in use.

So, while it is nice of the IRS to provide the option, electing to use the "safe harbor" deduction may not be the way to go.

--Written by Robert D. Flach for MainStreet

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