– By Mark Battersby – Everyone who runs his or her rural building business from a home office or uses a home office for management chores, will be happy to learn that the Internal Revenue Service has announced a new “safe harbor” that will allow them to deduct as much as $1,500 of the expenses of maintaining and operating that home office, all-the-while reducing the administrative, record keeping, and compliance burdens — and audit risk — faced by everyone who has ever attempted to claim a tax deduction for home office expenses.
The IRS’s new, simplified option, a so-called “Safe Harbor” will allow any builder or contractor, whether a worker, an employee of his or her own business, or the owner of a home-based building business to use a flat, no-questions-asked deduction of $5.00 per square foot of the part of the residence that is used for business purposes, not to exceed 300 square feet, for a maximum deduction of $1,500.
In general, home office expenses are tax deductible if part of the home is used regularly and exclusively as (1) a principal place of business, (2) a place to meet or deal with customers or clients in the ordinary course of business, or (3) in the case of a separate structure that is not attached to the dwelling unit, in connection with the taxpayer’s trade or business. Taxpayers who are employees must meet an additional test — their use of the home office must be for the convenience of the employer.
Fortunately, a taxpayer’s “place of business” includes a place used for administrative or management activities. This is especially helpful when there is no other fixed location where substantial administrative or management activities are conducted. Those who perform administrative or management activities at places other than the home office are not automatically prohibited from taking the deduction based on a failure to meet the principal place of business requirement.
The tax write-off for the expenses of maintaining an office in the home involves not one expense, but many. According to the IRS, the home office tax deductions will depend on two things: (a) whether the expense is direct, indirect or unrelated; and (b) the percentage of your home used for business.
Direct expenses are those expenses that are directly related to the business use of the home, such as painting of the home office. These types of expenses are deductible in full, subject to the deduction limit on business income.
Indirect expenses, such as insurance, utilities and general repairs, are deductible based on the percentage of the home used for business. These expenses are indirectly related to business use of the home office; rather, they relate to the entire home. Thus, if only 25 percent of the home is used as a place of business, only 25 percent of net rent or repairs can be deducted.
Unrelated expenses, or expenses for the parts of the home not used for business, are not deductible. Landscaping or lawn care, for example, cannot be deducted even if done to enhance the look of the business and home office (unless, of course, the taxpayer is in the landscaping business).
Rent: Rent is considered an indirect expense with the business portion deductible by anyone meeting the home office requirements. Those owning their home cannot deduct the fair rental value of the home office. Rather, they claim depreciation on the home office.
Insurance: A portion of homeowners or renters insurance is deductible by those qualifying for a home-office deduction, equivalent to the percentage of the home used for business. However, if there is additional coverage directly related to the home office, the additional expense is treated as a direct expense.
Casualty Losses: These are losses from fire, storm, theft, or vandalism. What can be deducted as a home business deduction is usually based on the property that suffers the loss. If it is a direct expense, meaning the loss is on the portion of the property used solely for business purposes, the entire loss can be deducted. If the loss involves property used for both business and personal purposes, such as a leak in the roof of the house, only the percentage of business use will be deducted.
Security: The business portion of amounts spent for the installation of a security system that protects the windows and doors of the home can deducted. The business portion of the monthly monitoring fees is an indirect expense.
Repairs: The cost of repairs, supplies and labor related to the building business, including the cost to repair the air-conditioning system of the house, is tax deductible. Since repairing the air-conditioning system benefits the entire house — and the home office — the deduction equals the percentage of home office use.
Utilities and Services: The IRS primarily considers expenses for utilities and services, such as electricity, gas, trash removal and cleaning services, as personal expenses. However, deducting the business part of these expenses is acceptable.
Property Taxes: A percentage of home property taxes can be claimed only if home office expense deduction is allowed.
One important caveat: Although the home office rules apply to sole proprietors, partners, owners of S-corporations, and members (owners) of LLCs, they do not apply to building businesses incorporated as regular “C” corporations. Home office deductions are reported on Form 8829, “Expenses for the Business Use of Your Home” and attached to the Form 1040.
Establishing a home office creates a secondary benefit: The ability to deduct travel expenses from home to business locations and back again. Since the home becomes a business location, driving from it to see a customer or vendor and returning home is a legitimately deductible business expense.
For those builders and contractors who own their home, claiming a home office deduction does not prevent them from claiming the home sale exclusion to avoid tax on gain up to $250,000 ($500,000 on a joint return). Naturally, any depreciation claimed with respect to the home office after May 6, 1997, must be “recaptured” or paid back, at the rate of 25 percent. This means the amount of depreciation reported is recaptured and one quarter of it must be “recovered” and paid back in taxes.
An additional side benefit of using the safe harbor is that claiming a home office deduction will likely be less of an audit flag. But reduced audit risk or not, is the safe harbor the most rewarding path?
An increasing number of builders and contractors are working at home or operating a business from their home and now they have the option of a new “safe harbor” deduction for home office expenses. Regardless of whether a home office is used for the convenience of an employer, a building business that is based in a home office, or the home office is used to supplement the business’s primary place of business, a tax deduction may be available.
The early introduction of this new option should allow everyone sufficient time to decide whether the safe harbor or deducting the actual expenses connected with maintaining a home office will be more advantageous for the 2013 tax year and the years that follow.