Many people maintain a home office (often a desk with a computer) from which to carry on a trade or business, whether it is related to their primary employment or a side-business. During the COVID-19 pandemic in the United States, many workers found themselves voluntarily or involuntarily working from home for long periods of time to prevent the spread of infection. Are the portions of the taxpayer’s home used for business allowable as a tax deduction?
As a general rule, the Internal Revenue Code prevents taxpayers from attempting to convert nondeductible personal expenses into “necessary and ordinary business expenses”. However, home business deductions are allowed for the following:
- The portion of the dwelling used regularly and exclusively as the principal place of business for any trade or business of the taxpayer. 26 U.S.C. 280A(c)(1)(A). “Principal place of business” includes a place of business which is used by the taxpayer for the administrative or management activities of any trade or business of the taxpayer if there is NO OTHER FIXED LOCATION of such trade or business where the taxpayer conducts substantial administrative or management activities of such trade or business. This does not apply to an employee of a trade or business.
- The portion of the dwelling used regularly and exclusively as a place of business which is used by patients, clients or customers in meeting or dealing with the taxpayer in the normal course of his trade or business. 26 U.S.C. §280A(c)(1)(B). The patient, client or customer must be physically present at your home and their use is substantial and integral to your trade or business. Doctors, dentists, lawyers, accountants and architects who meet clients at their home will usually qualify for this deduction. This does not apply to an employee of a trade or business.
- A separate structure NOT attached to the dwelling unit (e.g. barn, garage, workshop or studio) used regularly and exclusively in connection with the taxpayer’s trade or business. 26 U.S.C. §280A(c)(1)(C). This does not have to be the principal place of business or where you meet patients, clients or customers. In the case of an employee, this provision only applies if the exclusive use is for the convenience of his or her employer.
- Items attributable to the portion of the dwelling unit which is used on a regular (but not necessarily exclusive) basis as a storage unit for the inventory or product samples of the taxpayer held for use in the taxpayer’s trade or business of selling products at retail or wholesale, but ONLY if the dwelling unit is the sole fixed location of such trade or business. 26 U.S.C. §280A(c)(2).
- Items attributable to the use of any portion of the dwelling unit on a regular (but not necessarily exclusive) basis in the taxpayer’s trade or business or providing day care for children, individuals over age 65, or individuals who are physically or mentally incapable of caring for themselves. 26 U.S.C. §280A(c)(4)(A). The owner/operator of the day care service must have applied for, have been granted or is exempt from having an applicable license under state law. 26 U.S.C. §280A(c)(4)(B). If the portion of the dwelling unit is not exclusively used for day care purposes, then the amount of deductions shall be allowed at the same ratio as the number of hours the portion of the dwelling is used against the number of hours the portion of the dwelling is available. 26 U.S.C. §280A(c)(4)(C).
If exclusive use is required, then it means that portion of your home can ONLY be used for your trade or business. If you use a room in your home as both a home office for your business and a playroom for your children, then it is not used exclusively for purposes of a deduction. You can use the same home office for more than one trade or business, but you cannot use it for activities NOT related to a trade or business if exclusive use is required. If regular use is required, then the portion of your home doesn’t have to be exclusive BUT it has to be more than occasional or incidental under the circumstances. For example, using your dining room table as an attorney once in a while to write legal memos does not qualify as regular use.
If your gross income from the business use of your home is less than your total business deductions, then your deductions for certain expenses is limited to the gross income of your business MINUS the business part of expenses deductible if you did not use your home for business (mortgage interest, real estate taxes, casualty losses) and MINUS the business expense relating to the business but not the use of your home (office supplies and equipment, phone line). 26 U.S.C. §280A(c)(5).
What home business expenses are deductible?
- Direct expenses are those expenses that ONLY apply to the business use of your home and are deductible in full. They include, but are not limited to:
- Office Supplies (pens, pencils, paper, etc.)
- Telephone line (exclusively used in business part of office)
- Office furniture and equipment (may be subject to separate depreciation calculations)
- Painting and repairs ONLY in the business portion of the home.
- Indirect expenses are those expenses that are for keeping up and running your entire home. These expenses are deductible based on the percentage of your home used for business. For example, if you use 200 sq. ft. of your 2,000 sq. ft. home for a qualified home office, then you can allocate 10% of the indirect expense to your business. They include, but are not limited to:
- Home mortgage interest (but not principal) payments (ONLY if you can already claim as an itemized deduction on Form 1040 Schedule A).
- Real estate taxes (ONLY if you can already claim as an itemized deduction on Form 1040 Schedule A).
- Casualty losses attributable to a federally declared disaster (ONLY if you can already claim as an itemized deduction on Form 1040 Schedule A, but if you claim standard deduction then you may be able to increase this amount by net qualified disaster losses).
- Home insurance (only for those premiums that pay for coverage during the tax year).
- Rent payments (if you do not own your home).
- Home repairs that benefit the entire house (e.g. furnace, air conditioner, roof leaks).
- Home security systems (that protects all door and windows).
- Utilities (e.g. electricity, gas, water, trash removal).
- Depreciation (may claim a deduction allowance on your home every year for the wear and tear on the business use portion).
You can’t deduct home expenses that have nothing to do with the business portion of your home (e.g. lawn care services or tree removal, groceries, etc.).
A taxpayer can pick ONE OF TWO METHODS to calculate the home office deduction:
- ACTUAL EXPENSES: The taxpayer calculates the actual dollar value of the direct expenses, properly allocates the amount of the indirect expenses and subtracts them from the gross income of the trade or business.
- SIMPLIFIED METHOD: The taxpayer figures the deduction by multiplying $5.00 (the current prescribed rate) by the area of the home used for a qualified use (not to exceed 300 square feet). For example, if a taxpayer uses 150 sq. ft. of his or her home regularly and exclusively for business, he or she can deduct $750.00 as a home office deduction for the tax year.
A taxpayer can elect to use either the actual expense method or the simplified method in any tax year. If the taxpayer uses the actual expenses method and part of the deduction is limited because it exceeds gross income of the trade or business, then the disallowed portion can be carried over to the next tax year for a deduction. However, he or she cannot deduct any carryover of actual expenses in the same tax year the taxpayer elects to use the simplified method.
What if the taxpayer maintains a home office but practices his or her trade or business elsewhere? Can a deduction still be claimed?
In Commissioner v. Soliman, 506 U.S. 168; 113 S.Ct. 701; 121 L.Ed.2d. 634 (1993), the taxpayer was an anesthesiologist who practiced his profession in Maryland and Virginia during tax year 1983. He spent about 30 or 35 hours per week with patients across three hospitals, none of which provided him with an office. He utilized a spare bedroom in his condominium that he used exclusively as an office. Although he did not physically meet patients in the home office, he did spend 10 to 15 hours there performing tasks such as “contacting patients, surgeons, and hospitals by telephone; maintaining billing records and patient logs; preparing for treatments and presentations; satisfying continuing medical education requirements; and reading medical journals and books.” He claimed deductions on his 1983 federal tax return “for the portion of condominium fees, utilities, and depreciation attributable to the home office.” The IRS disallowed the deductions based on its determination that it was not Soliman’s principal place of business. The U.S. Tax Court disagreed and found the home office to be the taxpayer’s principal place of business under the following test:
- “[W]here management or administrative activities are essential to the taxpayer’s trade or business and the only available office space is in the taxpayer’s home, the `home office’ can be his `principal place of business,’ with the existence of the following factors weighing heavily in favor of a finding that the taxpayer’s `home office’ is his `principal place of business:’ (1) the office in the home is essential to the taxpayer’s business; (2) he spends a substantial amount of time there; and (3) there is no other location available for performance of the office functions of the business.”
The Fourth Circuit Court of Appeals agreed with the Tax Court and determined that the home officer was properly considered the “focal point” of his trade or business. However, the U.S. Supreme Court reversed both lower courts and found that Soliman’s home officer was NOT his principal place of business. Since the Internal Revenue Code does not define “principal place of business”, the Supreme Court decided that “the point where goods and services are delivered must be given great weight in determining the place where the most important functions are performed.” 506 U.S. at 175. In addition, 26 U.S.C. §280A(c)(1)(B), as drafted at the time, recognizes that “the home office gives rise to a deduction whenever the office is regularly and exclusively used “by patients, clients, or customers in meeting or dealing with the taxpayer in the normal course of his trade or business.” 506 U.S. at 175-176. The U.S. Supreme Court rejected the home office deduction since “[t]he practice of anesthesiology requires the medical doctor to treat patients under conditions demanding immediate, personal observation” at hospitals and treatment facilities where he spent 30 to 35 hours per week. 506 U.S. at 178. Wile the office may have been “essential” to his practice, it did not make it the principal place of business under the circumstances. 506 U.S. at 179.
Fortunately for taxpayers, Congress amended 26 U.S.C. §280A(c) in 1997 so that a home office could meet the “principal place of business” if it is “a place of business which is used by the taxpayer for the administrative or management activities of any trade or business of the taxpayer if there is NO OTHER FIXED LOCATION of such trade or business where the taxpayer conducts substantial administrative or management activities of such trade or business.” The U.S. Supreme Court’s decision in Commissioner v. Soliman was effectively nullified by legislative action. If an anesthesiologist performs his actual practice or treatment at hospitals but ONLY performs his administrative or management tasks at a home office, then the Internal Revenue Code will consider the home office to be the “principal place of business”. This is a major victory for professionals such as lawyers, accountants and doctors who may travel to various locations to engage in their profession but maintain their base at home (assuming they do not have an office address elsewhere).
Home office deductions have attracted much more IRS scrutiny in recent years because taxpayers usually fail to comply with the “regular and exclusive” use test. Claiming home office deductions will increase the chances of being audited. However, taxpayers should not be deterred from claiming these deductions if they otherwise comply with the law. If you have questions about home office deductions or need representation for an audit or examination, then do not hesitate to contact the experienced attorney at Kershaw, Vititoe & Jedinak PLC today.