Great new article by the AIPB!

When to use the new IRS home-office safe harbor

It turns out that deducting the actual expenses of a home office instead of using the IRS safe harbor does not always yield the biggest tax deduction. So, when should you use the IRS safe harbor v. actual expenses method?

The safe harbor lets you deduct on Schedule A $5/sq. ft., up to $1,500 (see our March and April issues) and prorate normally allowable home expenses such as mortgage interest, property taxes and casualty losses. But you cannot prorate a portion of actual house expenses—e.g., homeowners’ insurance, utilities and repairs.

Thus, to know which method to use you must consider both the amount of home-office expenses deductible from gross income v. home-related itemized expenses deducted on Schedule A.

An analysis published in Tax Notes Today found that in three hypothetical situations with different-sized homes, the actual expense method minimized Schedule C income—but the safe harbor method maximized Schedule A deductions.

The analysis found that for total tax savings, the safe harbor is best when the home-office is a smaller percentage of the home’s square footage: 10% in the examples. When a home office space is a larger percentage of the home (20%–25% in the examples) deducting actual expenses reduces taxes more.

But other factors can change the results.

For example, if personal income exceeds the Social Security wage base, the safe harbor method saves more on taxes because the higher Schedule C reduction offered by taking actual expenses becomes less beneficial when it stops reducing the self-employment tax as well as FIT.

Other factors that change results include whether your total itemized deductions or other tax benefits are subject to various phase outs as your adjusted gross income rises. In addition, actual expenses that affect only the home office but not the rest of the home might be deductible in their entirety as actual home office expenses. Nor does the safe harbor permit the depreciation of the home office; on the other hand, when depreciation is taken, it reduces the basis of the home.

  

You can alternate between the two methods each year, so a taxpayer who wants to maximize deductions should calculate both methods annually (tax software should let you compare these methods). Keep in mind non-tax factors. The safe harbor method reduces audit risk—safe harbors always do, because they result in lower tax deductions than taking actual expenses. It also reduces recordkeeping and the cost of tax preparation.