The December tax overhaul, which radically altered the economics of homeownership, will put a crimp in the budgets of many Americans. If you are self-employed and work at home, there’s a strategy to help ease the pain: Take a home office deduction.
This deduction is nothing new, but recent tax law changes make it more appealing. Why? Because starting with the 2018 tax year, this is one of the few ways you can still deduct property taxes.
Previously, whether or not you worked at home, you could deduct this expense on Schedule A of Form 1040, the federal income tax return. This is the place where you itemize, or list, each deduction to which you are entitled. The alternative is to take what’s called the standard deduction, in which case you would not file Schedule A. Either way, deductions reduce the amount of income that’s subject to tax.
What’s a deduction worth? Its approximate value to you, in pocket, is the amount you are deducting, multiplied by the tax rate that applies to you in a given year. That’s true whether you take the standard deduction or itemize.
Starting this year (in other words, affecting the return you file in April 2019), many more people will take the standard deduction, rather than itemize. Two elements of the latest tax act will be driving that trend. First, it roughly doubles the standard deduction, to $12,000 for individuals and $24,000 for married couples filing jointly. The other new development is that the law sets a $10,000 cap on the total deduction for real estate taxes; state and local income taxes; and sales tax. Between that and other deductions that have been eliminated entirely, few of us will have enough to itemize.
As a practical matter, a deduction for real estate taxes is worthless unless you itemize. For a rough idea of whether you will be worse off, turn to Schedule A of your most recent federal income tax return and follow these steps: 1) Total the amounts on line 5 (state and local income taxes, and sales tax) and line 6 (real estate taxes); and 2) Subtract $10,000 (the new cap) from the amount in No. 1. If the answer is more than the 2018 standard deduction, the changes put you at a disadvantage.
Here’s where the home office deduction – if you qualify for it – can help: Though you can’t deduct everything you pay for real estate taxes, you can allocate some of it to your business use of the home. What you’re losing, under the new tax law, is the ability to deduct the portion attributable to your personal use.
Note: Though employees used to be able to take the home office deduction in some cases as an unreimbursed job expense, starting with the 2018 tax return they can no longer do that. For them, this expense previously came under the Schedule A heading, “Job Expenses and Certain Miscellaneous Deductions.” This category, which covered a wide variety of expenses that could be deducted if they totaled more than 2 percent of your adjusted gross income, has been eliminated.
In contrast, if you’re a freelancer or are self-employed, and operate as a sole proprietor, you can continue to deduct the cost of a home office, along with other business expenses, on your Schedule C. That’s something to consider for the 2017 tax year (the tax return that’s due April 17), though you don’t yet have the state and local tax limits to contend with. And it could be even more beneficial going forward, since the new $10,000 cap applies from now until the end of 2025.
As in the past, taking a home office deduction might flag you for an Internal Revenue Service audit. So it’s important to follow the rules.
For starters, you must devote the space exclusively to business on a regular basis. That doesn’t mean you need an entire room set aside for the purpose – just that you can’t use the area for other activities. For instance, if your home office doubles as a TV room, it’s usually not deductible. Two exceptions: If you run a day care facility from your home, or store inventory or product samples there, you don’t have to meet the “exclusive use” test.
Next, the IRS looks at the type of space and the role it plays in your business. Easiest to qualify are separate structures, such as studios, unattached garages or barns. You can deduct the expense of these areas if you use them in your trade or business.
With other parts of your home, the rules get more stringent. The office must be either your “principal place of business,” or a space where you meet clients or customers. Your home qualifies as your principal place of business if you conduct administrative or management activities there, instead of running your company entirely from another place. The office doesn’t even have to be the only one, as long as you don’t conduct “substantial administrative or management activities” somewhere else.
Assuming you meet the various tests, you can deduct both direct and indirect expenses of running a home office. Direct expenses, which are fully deductible, benefit only the business part of your home – painting the room that you use as an office, for example. Indirect expenses affect both the business and principal parts of the house (or apartment). They include: utilities; insurance; general repairs; burglar alarms; mortgage interest; and real estate taxes.
For indirect expenses, you’ll need to determine how much of your home is used exclusively for business, or to store inventory or product samples. The easiest way to do this is to measure the total floor space and figure out, as a percentage of that area, how much of it your office occupies.
If you are a sole proprietor and do your own taxes using the TurboTax Home & Business Tax Software, it will step you through this process, as well as the choice you have: whether to deduct a percentage of your actual expenses (which requires you to have receipts), or take a simplified deduction based only on the square footage of your home.
Don’t have good records or receipts to back up your expenses? You might prefer the latter, but it is likely to result in a lower deduction. The deduction using the simplified method is capped at $1,500 per year based on $5 a square foot for up to 300 square feet. More importantly, with the simplified approach, you can’t deduct actual expenses, so it doesn’t help you overcome the restrictions of the new tax law. Again, that doesn’t matter for the 2017 tax return now on your mind, but it could make a big difference for the one you’ll be contemplating a year from now.
Another thing you lose, by taking the simplified deduction, is the right to depreciate the portion of your home used in a trade or business. This is another reason you might not want to go this route.
Depreciation – a gradual reduction in the value of the house (but not the land) – is also based on what portion of your home is used for business. Your total depreciation is that percentage times either the adjusted basis (the cost of the house plus capital improvements), when you install your home office, or the fair market value at that time, whichever is less. Typically you would spread those deductions out over 39 years.
To deduct actual expenses and depreciation, sole proprietors must file Form 8829, “Expenses for Business Use of Your Home,” along with Schedule C. If you use TurboTax, based on the information you provide, it will generate Form 8829. (Renters might prefer to use the simplified method, which doesn’t necessitate filing Form 8829.)
With either system, you can’t take a home office deduction if your business is operating at a loss. (For more details on the home office deduction you can download IRS Publication 587, “Business Use of Your Home.”)
If you use a corporate format for your business, rather than operating as a sole proprietorship, the same rules apply, but the accounting and reporting methods are more cumbersome. Consult your tax adviser.
Finally, if your ability to take the regular (rather than the simplified) home office deduction this year was constrained by a lack of receipts, start being more vigilant about record-keeping for 2018. That way, you’ll have all the documentation necessary when the next tax season rolls around.
Deborah L. Jacobs, a lawyer and journalist, is the author of Estate Planning Smarts: A Practical, User-Friendly, Action-Oriented Guide. A free update to the book, reflecting the recent tax overhaul, is available for download on the book’s website. Follow Deborah on Twitter at @djworking and join her on Facebook here. You can subscribe to future blog posts by using the sign-up box on the homepage of her author’s website.
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