Do you qualify for a home office deduction for tax purposes?
I was recently in a Zoom meeting with a client in Australia discussing business. Our casual conversation had to do with COVID-19 and how he was dealing with the lockdown his state was experiencing. Residents could be outside 1 hour a day and only travel less than 5 miles from their house during the spike of cases in their area (imagine having those restrictions here in the United States). He mentioned how it was a bummer because he liked to regularly visit a meat butcher at a grocery just outside the travel restriction and used that butcher exclusively through the years. He was now forced to make his purchases from a butcher at a local grocery within the travel restriction.
Our conversation got me to thinking about regular and exclusive use and the importance it may hold for real estate investors. Eligible real estate investors may take a business use of home deduction so long as they qualify. The business use of home deduction allows business owners in a trade or business to expense costs related to their home such as real estate taxes, mortgage interest/rent, insurance, utilities, depreciation, maintenance, etc. provided they use a space in their home regularly and exclusively for the purpose of their business.
To be eligible the trade or business must also satisfy one of three additional requirements including: performing administrative and management work at home, performing the most important rental activities at home or meeting business visitors at the home office. I believe the business use of home deduction has been misunderstood by many taxpayers for a while now. There is a fear in some taxpayers that by taking the deduction it would increase their chance of being audited.
I’ll pause on getting too deep into this deduction explanation without first discussing a hurdle that taxpayers need to pass before they can even consider the steps to qualify for the deduction. It’s important to understand not all real estate investors can take this deduction. First, an investor needs to determine whether their rental real estate activity rises to the level of a trade or business.
Are You a Trade or Business?
The rules to determine a trade or business are not well defined. Generally, if you regularly and continually conduct your rental real estate activity and your primary purpose is to earn a profit, then you may be a trade or business. There are several factors used by IRS to assist with making this determination and include the number of rental properties you own, the time you or your managers spend working with the properties, how long the lease is, whether it is commercial or residential and confirming if you filed 1099’s for any service you paid for.
The last factor is really important because real estate investors often fail to file 1099’s which could disqualify them from not only the business use of home deduction, but also the pass-through deduction (199a), ability to use section 179 and startup expenses.
You should document your reasoning for your belief your rental property is a trade or business. It will be very helpful in the event you ever do get audited. Now that you determined you’ve passed the trade or business hurdle; you can focus your attention back on the business use of home deduction.
Itemizing Deductions Is More Difficult
The 2017 Tax Cuts and Jobs Act brought about sweeping changes to the way businesses and individuals are taxed. A few of those changes involved increasing the standard deduction as well as reducing the amount of property, state and local taxes that may be deducted on the Schedule A. Based on these changes less than 10% of taxpayers are now able to itemize deductions on their personal returns. Without being able to itemize, many taxpayers no longer get a benefit for the interest or real estate taxes they pay on their personal residence.
Definiting Your Home Office Space
But for real estate investors who have a trade or business they may still get a benefit for those expenses if they have a dedicated space in their home in which they run their business. Using your home office exclusively for your rental trade or business involves defining a space in your home which may be a room or a corner in your basement for example, that is dedicated to only your business. You would not want to have anything personal in the space. Your office space can’t just sit there though. You need to perform work on a regular basis. You’ll do that by keeping your accounting books and records, billing tenants, scheduling tenant showings, storing rental signs, etc. in your home office.
Tax Savings Using Home Office Deduction
You may ask what the fuss is all about in getting a deduction for using a home office? Imagine if you were single and your only source of income (which happens to be $100,000) came from your real estate business. If you do a good job tracking your home expenses mentioned earlier, you calculate $20,000 in total home expenses including depreciation. Let’s say you’ve determined your office space is 400 square feet in your 2,000 square foot home. That results in a $4,000 expense deduction from your net income which would be a $880 tax savings for a single individual in the 22% tax bracket.
Generally, to calculate the Actual Expense method you would determine the total square footage of your home. Next you would determine the square footage of your office space. Be sure to take a picture of the office space as well as documenting on paper how you calculated the square feet for your office and home. Divide the square feet of your office by the total square feet of your home and you have the business use percentage of your home.
Through the year you’ll want to keep track of payments and invoices for home expenses such as those previously mentioned. At the end of the year you would multiply your total expenses by the business use percentage and those are the allowable expenses for your home.
Maximize Auto Expenses Using Home Office Deduction
How many of you deduct auto expenses? If this were a classroom, I would expect everyone in the room to be raising their hands. How many use the standard mileage rate and include travel from their home to their rental or flip properties as business mileage? Again, if this were a classroom, I would expect a few hands would be raised. However, those raising their hands want to pay close attention here. Travel from your home to a business location is considered a commute. Therefore, it is personal travel and generally, not includable as a business expense.
The catch here is that if you have a home office, your travel from home office to your rental or flip property would be considered deductible as business travel. Therefore, you have increased your tax savings by maximizing your deductions.
Depreciation Is Allowed or Allowable
Don’t forget to calculate the depreciation of your home. This is very important because this is where I see mistakes made by not only taxpayers, but their tax advisors as well.
You may recall that you may exclude gain on the sale of your personal residence up to $250,000 for a single individual and $500,000 for a married couple. If you have taken depreciation via the business use of home deduction, you’ll need to factor that into your gain on home sale exclusion.
For example, if you sold your personal residence at a gain of $200,000 but had allowed depreciation through the years from the home office deduction of $10,000, you’ll need to reduce your gain exclusion by $10,000. In addition, the $10,000 is taxed at ordinary gain up to 25%.
I’ve heard of instances where a taxpayer is consulted by their tax advisor to just forgo the depreciation but take the other home expenses as a home office deduction. This is not good advice as the law states the home sale exclusion is based on the depreciation allowed or allowable. That means you must reduce your exclusion by the depreciation whether you took it as a deduction or not in prior years.
The goal of tax planning is to defer tax liability and kick the can down the road as long and far as possible before having to pay. In some cases, taxpayers may not like the idea of having to pay tax on the depreciation recapture but are not factoring in the tax savings they have had through the years prior to selling their home by taking advantage of the depreciation.
Document and Keep Good Records
You may have read through other articles or social media posts I’ve had in the past and noticed I have a common theme regarding documentation and good record keeping. My experience through the years regarding documentation and good record keeping is that if a taxpayer keeps good records, they won’t have to worry about losing an audit to the IRS.
My belief is every time a tax return is filed it is 100% correct. It’s only when a return is audited that the percentage of correctness may decrease. What causes the decrease? I believe poor recordkeeping as well as taking an extremely aggressive stance on deductions. For example, do you really think 45,000 business miles for a Landlord owning 2 properties within a 30-mile radius of their home is believable for the auto expense deduction?
Therefore, if you have discussed the home office deduction with your tax advisor, understood how to qualify and properly document your reasoning, you won’t have a problem with taking this deduction and reducing your tax liability.
Tax Advisor Relationship
There are rules to follow when taking tax deductions on your return. Those rules are not always black and white, but if you and your tax advisor take the time up front to document your stance, you’ll have a much smoother ride if you must endure an IRS audit.
Generally, this is where your tax advisor earns his pay. If you shop around tax advisors based on price, make sure you take into consideration the “advising” part of your relationship. Many taxpayers balk at a cost quoted by a tax advisor because they may only be considering the tax return, but do not realize there is much more to the relationship than a tax return. Planning and advising is much more important than the actual preparation of the return.
The Easy Calculation
You’ve made it this far into the article (hopefully) and may decide the work to save $1,000 in taxes is more than you’re willing to accept and are thinking you’ll pass on the business use of home deduction. Don’t leave me yet. I’d like to introduce you to the Simplified Method. You calculate the Simplified Method by multiplying $5 to each square foot in your office up to 300 square feet. Therefore, you could have a maximum deduction of $1,500 to help reduce your real estate net income. It’s a much smaller savings, but a much easier calculation that you should take advantage of assuming you qualify for the deduction to begin with.
Net Loss In Current Year Suspends Home Office Deduction To Future Years
Also, please note that your home office deduction cannot cause your business to have a net loss. For example, if you have Schedule E net income of $1,400 prior to including the Actual Expense Method deduction of $1,500, you could only deduct $1,400 of the home office deduction. The remaining $100 loss is allowable but gets suspended to a future year when you have net income.
This may ring a bell to some of you reading this article. You may have decided you didn’t want to pursue the home office deduction because it didn’t create a loss. You may not have considered you still get to take advantage of the deduction, but in a future year. Each year you are unable to fully use the deduction, it gets suspended to future years and helps to reduce income at that time.
In Closing
So the next time you’re out at a restaurant way across town and thinking about how crazy the COVID-19 restrictions have been here in the United States think about my client down in Australia who spent several months being locked down in his home with his biggest decision to make each day being whether he would get up out of bed. Also, consider the business use of home deduction. It is likely one of the best deductions that most taxpayers do not take advantage of for the sole purpose of their fear of being audited. Follow the rules and cut your taxes!
Feel free to reach out to me for help. You can also check our COVID-19 Resource Center for ongoing news and resources.
This article was previously published by the Kentucky Real Estate Investors Association and is reprinted here with permission.