Now that 2020 is behind us, few will mourn its end. Millions of Americans made significant and unplanned adjustments in their personal and professional lives. People turned their dining rooms, living rooms, basements, and bedrooms into make-shift offices. Some were able to fulfill their professional responsibilities at full, or near full capacity in the remote work environment. Others were not as fortunate, and many did not retain their prior positions of employment. In addition, there are many who started their own businesses as they joined the growing gig economy. With the tax filing season just around the corner, I repeatedly hear the question, “can I deduct my home office?” The answer varies as the IRS has a more restrictive definition of the home office than those heard in ordinary conversation.

In the spirit of 2020, I will start with the bad news. Anyone who is working from home as an employee cannot take a home office deduction. This rule is not new to 2020. In other words, if you receive a W-2 from your employer, you are generally ineligible. An exception is made for statutory employees, such as full-time life insurance agents. On the other hand, employees cannot deduct the regular commuting costs for their jobs. Therefore, the new telecommuters will receive an increase in their ordinary cash flow through reduced costs of gas, tolls and car maintenance.

In the next section of this article, I will describe the hurdles an individual must clear in order to qualify for the home office deduction:

Trade or Business

  • The taxpayer must be engaged in a trade or business on a regular and continuous basis.
    • An investment advisor who maintains an active brokerage license and buys and sells securities on behalf of clients for a fee qualifies.
    • An individual who reads the Wall Street Journal and buys and sells his or her stocks in an E-Trade account is not engaged in a trade or business.
  • The trade or business must have a profit motive, not simply be a personal hobby.
    • The Hobby Loss rules presume a business is not a hobby if it has generated a profit in three of the preceding five years, including the most recent year. The IRS must prove otherwise.
    • A business is presumed to be a hobby if it has failed to generate a profit in three of the five preceding years. The taxpayer must prove otherwise if the IRS challenges the intent.

Home Office Definition

  • A home office should be viewed in the order of the two words – it is a home first and an office second.
  • The IRS requires the taxpayer to either own or rent one of the following types of dwelling units:
    • house
    • apartment
    • cooperative apartment
    • condominium
    • mobile home
    • recreational vehicle
    • boat with full living accommodations (bed, kitchen, toilet, etc.)
  • The taxpayer must identify a specific portion of the dwelling unit as designated for exclusive and regular use as an office.
    • The exclusive use requirement is the more confusing of the two. In Publication 587, The IRS permits “..a room or other separately identifiable space. The space does not need to be marked off by a permanent partition.”
      • This should come as good news for those who have unexpectedly had to block off portions of rooms of their homes for office space. Business owners who live in efficiency apartments were utilizing this rule to take the home office deduction before COVID-19 hit.
  • The taxpayer must also be able to substantiate that the home is either the principal place of business or used for significant meetings with customers, clients or patients.
    • The principal place of business requirement only pertains to administrative or management activities. These would include setting up meetings, receiving and remitting payments, and maintaining business records.
    • It is expected that a business owner will engage in significant non-administrative activities outside the home. Think of a doctor who must see patients in a hospital or an electrician who works on electrical wiring in people’s homes or office buildings.
  • Once the taxpayer has met the requirements of the home office, he or she will need to determine the portion of the home that qualifies. This figure is calculated by dividing the area of the office portion over the total area of the house. It will be used as the percentage of expenses that can be taken.

Permissible Expenses

  • The IRS permits deductions for both direct expenses and indirect expenses.
    • o Direct expenses consist of those costs attributable only to the business portion of the home. This would include such costs as painting or decorating the room used as the home office.
    • o Indirect expenses are costs that apply to the entire home. They include a much more extensive list of costs:
      • Interest
      • Real Estate Taxes
      • Repairs and General Maintenance
      • Utilities
      • Insurance
  • Direct expenses are deductible in full.
  • Indirect expenses are aggregated and then multiplied by the home office percentage.
  • The direct expenses and deductible indirect expenses can be taken against an individual taxpayer’s trade or business income. They cannot create a loss for the current year but can be preserved for subsequent years.
  • All disallowed home office expenses are carried forward to be used against future business income.

Conclusion

2020 has been a tough year for everyone, regardless of geography or profession. Think about whether you might qualify for a home office deduction. Make sure to keep good records of all your home expenses so your deduction can be calculated accurately and completely. An unexpected tax refund can be a helpful step in getting 2021 off to a good start.

Questions about your home office deduction? Contact us today.