Home Office Deduction

By Jason Watson, CPA
Posted Saturday, September 21, 2024

A home office is simply another work location, where your commute is now from the bedroom to the basement, and your travel between work locations is considered business travel and therefore deductible. The home office deduction in itself is not that thrilling, but when it changes the color of money and converts commuting expenses into deductible business travel, it has some teeth. What are the rules for claiming a home office?

IRC Section 280A reads in part-

So, what are the exceptions?

• Certain business use (typical home office, and discussed more here)

• Certain storage use

• Rental use (tax free… 14-day “Master’s” or “Augusta” rule)

• Providing day care services

IRC Section 280A continues by reading-

Let’s review some of the buzzwords above. Exclusive means the identifiable space or room is used only for business purposes (so let’s not have a bed in your home office).

Regular is squishier since it is a facts and circumstances evaluation. Spending 4 hours a month selling Etsy stuff online or managing your rental property won’t win too many arguments.

Principal place of business was once a hot topic but has been tightened up with this language from IRC Section 280A(c)(1)(C)–

Administrative or management activities include a nice list from IRS Publication 587 Business Use of Your Home such as billing customers, guests, clients, or patients, keeping books and records, ordering supplies, setting up appointments, forwarding orders or writing reports (we list more below).

We have discussed this in other sections, but we’ll do it again here. A trade or business has been defined in Commissioner v. Groetzinger, 480 U.S. 23, and reads in part-

To be engaged in a trade or business, the taxpayer must be involved in the activity with continuity and regularity and that the taxpayer’s primary purpose for engaging in the activity must be for income or profit. A sporadic activity, a hobby, or an amusement does not qualify.

As such, to claim a home office with your rental property activities you must-

• Have an exclusive space that you use regularly,

• To perform administrative or managerial activities, and

• Be involved with your rental property activities with continuity and regularity with a profit-motive.

Is being a Real Estate Professional strongly support a home office claim? Likely.

Commercial property with several tenants? Likely. The same commercial property with a single user (think standalone Starbucks or Auto Zone building)? Unlikely.

Does having a single short-term rental support a home office claim? Less likely than above, but not impossible.

Can you claim a home office with a single long-term rental? Unlikely.

What about three rental properties? Perhaps, and now we are getting more into a facts and circumstances argument which is good and bad. Good, because there isn’t a bright line. Bad, because someone might disagree with you, and you will need to craft an argument.

Multiple Work Locations

While this might not be important for the typical rental property owner, it might be pertinent for the home builder or real estate agent. You can have multiple work locations. The IRS states that if you use a home office as your primary location for substantial administrative activities you are allowed to essentially have two work locations. For example, you own a landscaping business, and you have an office in your shop.

You perform all your administrative activities such as hiring and firing employees, accounting, balancing your checkbook, talking to your attorney, chatting it up with your real estate CPAs at WCG, etc. in your home office, that office counts as a work location in addition to your office in your shop. Here is the play-by-play blurb from IRS Publication 587 Business Use of Your Home-

You can have more than one business location, including your home, for a single trade or business. To qualify to deduct the expenses for the business use of your home under the principal place of business test, your home must be your principal place of business for that trade or business. To determine whether your home is your principal place of business, you must consider:

1. The relative importance of the activities performed at each place where you conduct business, and

2. The amount of time spent at each place where you conduct business.

Your home office will qualify as your principal place of business if you meet the following requirements.

1. You use it exclusively and regularly for administrative or management activities of your trade or business.

2. You have no other fixed location where you conduct substantial administrative or management activities of your trade or business.

Home Office Safe Harbor

There is a safe harbor provision for home office deductions where you can deduct $5 per square foot up to $1,500. For rental property owners and real estate investors, there are some real advantages for using the safe harbor method such as being able to use all mortgage interest on Schedule A instead of an allocation. Another benefit is the reduced recordkeeping requirements (safe harbors commonly have an element of reduced taxpayer burden of proof).

But there are also some limitations that need to be considered. WCG CPAs & Advisors typically optimize for both methods in these situations.

What about the real estate broker, or fix and flipper, where you are using an S corporation? According to IRS Revenue Procedure 2013-13 which reads in part-

02 Reimbursement or other expense allowance arrangement. The safe harbor method provided by this revenue procedure does not apply to an employee with a home office if the employee receives advances, allowances, or reimbursements for expenses related to the qualified business use of the employee’s home under a reimbursement or other expense allowance arrangement (as defined in § 1.62-2) with his or her employer.

An expense allowance arrangement is synonymous with an Accountable Plan which is how an S Corp shareholder is being reimbursed for a home office since they are also considered an employee.

Home Office Depreciation

Similar to rental properties (among other things), depreciation on a home office is required by the IRS. Here is a Q&A from their website under Sale or Trade of Business, Depreciation, Rentals > Depreciation & Recapture #3-

Question- I have a home office. Can I deduct expenses like mortgage, utilities, etc., but not deduct depreciation so that when I sell this house the basis won’t be affected?

Answer- No. All allowed or allowable depreciation must be considered at the time of sale. You can generally figure depreciation on the business use portion of your home up to the gross income limitation, over a 39-year recovery period and using the mid-month convention. As long as you determine actual expenses and the correct amount of allowed or allowable depreciation, the depreciation reduces the basis of your home accordingly, whether or not you actually claim it on your tax return.

Note that last phrase, “whether or not you actually claim it on your tax return.” That is the kicker. Truth be known, when a client sells their primary residence most tax professionals do not ask if it was ever used as a home office. Right, wrong or indifferent, it is often overlooked.

Additionally, home office depreciation is tough to track within a tax return. Sure, if you are a disregarded LLC or sole proprietor and reporting your business activities on Schedule C, you will use Form 8829 to generate the home office deduction and that form helps track home office depreciation. Easy. But as we discuss below, at times you are crunching these numbers separately from a tax form.

If you use the simplified method for the home office deduction, you do not have a depreciation recapture problem since you do not have to depreciate your home office. Back to easy again.

Home Office Deduction Mechanics

Ok, you have a home office for your rental property. Neat. How is it ultimately deducted on your tax returns? If you sold widgets as a sole proprietor or a single-member LLC as disregarded entity, you would report the home office details on Form 8829 Expenses for Business Use of Your Home. Simple.

If you operated an S corporation, you would be reimbursed by the business through an Accountable Plan. The tax deduction would occur on the S Corp tax return (Form 1120S). Simple and easy.

For rental properties, the calculus is similar to an Accountable Plan. You figure out the business use percentage typically using square footage, and then apply that percentage against various expenses such as mortgage interest, property taxes, utilities, insurance, maintenance, cleaning, HOA dues, etc.

That is the easy part. The challenging part is the deduction itself. Generally, a home office deduction cannot create a loss, nor can it increase a loss. However, only certain allocated expenses such as mortgage interest and real estate taxes are allowed to increase a rental property loss. This loss in turn is either limited by passive activity loss limitations or it is deducted (for example, a real estate professional or short-term rental situation).

Home office depreciation would be tracked separately as a carryover and deducted should the rental activity become profitable.

Other allocated expenses such as utilities, insurance, maintenance, cleaning, HOA dues, etc. which are personal in nature are lost. However, should the rental property be profitable in the future, these allocated expenses for that particular tax year would be tax deductible (but you cannot go back in time and claim lost deductions from prior years).

Keep in mind the allocation of general expenses across multiple rental properties that we discussed in a previous section. Using that logic, here is a conundrum- let’s say you have two rental properties where one grosses $100,000 in rental income and the other grosses $50,000.

Do you allocate your home office expenses 2/3 and 1/3 respectively? Seems simple, but that might not provide the best tax deduction based on some of those lost home office expenses given the ultimate rental activity profitability. What if the $100,000 rental property is a commercial office building with a bunch of headaches and problems? Could you argue an 85% and 15% allocation for home office expenses? Perhaps.

Back to the mechanics-

• For a typical rental property activity reported on your individual tax return (Form 1040), you would use Form 8829 Expenses for Business Use of Your Home which is detailed as Other Expenses on Schedule E. Alternatively, you could compute the home office deduction separately, or off-book if you will, and list the expense directly in Other Expenses.

• For the same situation above, but with multiple rentals, you would need to calculate the home office expense including limitations, allocate among the various rentals according to reasonable and consistent method, and list in Other Expenses.

• For a rental property reported on a partnership tax return (Form 1065), you could either calculate the home office expense including limitations and list on Form 8825 as Other Expenses, or preferably you would deduct the home office expense as unreimbursed partnership expenses (UPE) on your individual tax return using Form 8829. Another benefit is that deducting home office expenses using UPE is that the rental activities are netted together at the entity level, and as such, you don’t have to allocate among the underlying rental properties subject to certain limitations.

We chopped a lot of wood as they say! WCG CPAs & Advisors can help navigate the home office deduction for your rental properties and real estate investments.

Recall how we started this section by saying- A home office is simply another work location, where your commute is now from the bedroom to the basement, and your travel between work locations is considered business travel and therefore deductible. The home office deduction in itself is not that thrilling, but when it changes the color of money and converts commuting expenses into deductible rental property travel, it has some teeth.