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.