The Home Office Deduction Audit Risk Myth
Every year more people are concerned that taking a home office deduction isn’t worth the risk because the deduction could trigger an IRS audit. There is no question the home office deduction is a real, legitimate deduction that qualifying homeowners should not ignore.
The real question is twofold: 1. Why do people believe taking advantage of a legitimate deduction can trigger an IRS audit and 2. What steps can you take to ensure that your home office deduction is accurate?
Where Did the Home Office Deduction Audit Risk Myth Come From?
The home office deduction has been around for a long time. The Internal Revenue Service has allowed some form of home office deduction dating back to IRC sections 262 and 263 in 1959 which labeled all expenses of maintaining a household non-deductible unless the taxpayer “uses part of the house as his place of business”.
Tax Code Changes and Supreme Court Decisions
The Tax Reform Act of 1976 introduced Section 280A which is what allows you to deduct items like utilities, insurance, and depreciation on a pro rata basis. Since then, about once a decade there is a notable change in IRS rules and/or Supreme Court decisions that impact how 280A is applied and who qualifies for it.
The core of the myth stems from IRS tax code change and Supreme Court decisions because in some cases taxpayers, who in good faith, took the deduction had to pay the deduction amount back for the prior year.
The IRS Computer System - Discriminant Information Function Makes It Easier to Identify Red Flags
The IRS has a computer system known as the Discriminant Information Function (DIF). This system is designed to detect notable anomalies in tax returns within your profession. One function of DIF is to compare your tax return to other taxpayers with similar tax profiles.
For example, if the average person in your profession deducts 5% of their income for travel and you deduct 20% of your income for travel then you may appear as an anomaly which will increase your risk of an audit. In terms of the home office deduction, this does not mean you should not take the deduction it simply means your deduction needs to be reasonable and well-documented.
An Overlooked Change in 2020 Will Keep This Myth Alive
In March, The IRS created a new Fraud Enforcement Office which resides in the IRS Small Business/Self Employed Division. While this office will handle agency-wide fraud issues, its location in the IRS Small Business/Self Employed Division will continue to fuel this myth.
The Small Business/Self Employed Division currently oversees approximately 57 million taxpayers. This includes about 9 million small businesses. The new Fraud Enforcement Office provides additional resources to combat tax fraud (both intentional and accidental).
What Does This Mean for You?
The goal of this office is to focus on three types of tax situations:
1. Underreported tax obligations (Not reporting all of your income or overstating your expenses/deductions)
2. Underpayment of tax obligations (Not making your payments on time or in the proper amount)
3. Failure to file tax returns.
The big picture implication is as a small business or solopreneur you need to make tax filing, tax payments, and compliance a priority.
What Factors Related to the Home Office Deduction Could Trigger an Audit?
Keep in mind that in most cases, the home office deduction alone will not trigger an IRS audit, but it could be a red flag that, in conjunction with other factors, may make your tax return more likely to be audited. It is important to remember this deduction is only for the home office space and does not include your normal business expenses.
To minimize the risk of your home office deduction becoming a red flag you need to ask yourself the following questions.
Are You a Qualifying Taxpayer?
You are a qualifying taxpayer for the home office deduction if you fall into one of the following groups:
· You are self-employed
· You are an independent contractor
· You work in the gig economy
You do NOT qualify if you are an employee. If you receive a paycheck or a W-2 exclusively from an employer, you are not eligible for this deduction. The Tax Cuts and Jobs Act suspended the home office deduction for employees from 2018-2025. Assuming this provision is not extended, employees will again be eligible for this deduction in 2026.
What Does “Home” Mean?
The term “home” includes several different types of structures. It includes the traditional primary residence (house, apartment, condominium, mobile home, and boat) and structures on your property such as studio or unattached garage/barn. It does not include any part of your property that is used as a hotel, motel, inn, or similar business. For example, if you live on-site at your motel you would not qualify for the home office deduction.
Are You Using Your Home Office in a Manner that Qualifies for the Deduction?
The IRS has established two basic requirements for this deduction.
1. You need to use a portion of the home exclusively for conducting business on a regular basis. This is known as the exclusive use rule.
2. Your home must be your principal place of business
To claim your home office deduction, the IRS states a taxpayer must use part of your home for one (or more) of the following:
- Exclusively and regularly as the principal place of business for a trade or business
- Exclusively and regularly as a place to see patients, customers, or clients in the normal course of business
- On a regular basis for storage of inventory or product samples
- For rental use
- As a daycare
This does not mean you need an entirely separate room for your home office but the space must be a dedicated office space (a clearly separated area within a room can suffice). It cannot be a shared space such as your kitchen table or a desk in your living room.
What Are Your Qualified Expenses?
Deductible expenses related to your home office include:
- Real Estate Taxes
- Mortgage Interest
- Casualty losses
You cannot include household expenses that are for parts of your house that is not used for business purposes. For example, lawn care or painting a different room of your house would not be considered a qualified expense.
The Two Methods of Determining the Home Office Deduction Amount
Once you have determined that you do qualify for the home office deduction, the next step is determining which method you want to use to calculate the deduction amount. The IRS gives taxpayers two calculation options – Regular or Simplified.
The Regular Method
To use the regular method, you will add up all the qualified home office expenses of operating your home and divide them between personal and business use.
When using this method, you will complete Form 8829 Expenses for Business Use of Your Home and attach it to your tax return. If you moved during the year, you would need to complete a separate Form 8829 for each home. While filling out another tax form never sounds appealing, this form is surprisingly straightforward and easy to use.
The Simplified Method
To use the simple method, you measure the space of your home office or place where you conduct business and multiply the space by the square foot rate (square footage) designated by the IRS. Currently, the rate is $5 per square foot with a maximum deduction of $1,500.
A unique caveat to the simple method applies if you had a home office in more than one home during the year. You can use the simplified method for one home, but any other home would regular the regular method. You cannot use the simplified method for each home.
Which Method is Right for You?
When choosing between the simplified method or regular here are a few key considerations.
In almost every case, most CPAs and tax preparers would say the regular method will provide a greater deduction for freelancers, but everyone’s situation is different. It might be worth the time to double-check. You can use this home office deduction spreadsheet to manually calculate your deduction.
How Much Documentation Do You Maintain (Want to Maintain)?
The regular method requires you to keep track of all qualifying expenses and the accompanying documentation. The simple method is simply measuring your home office space and multiplying it by the square foot rate. No additional documentation is required to be kept. This makes the simple method much easier.
How to Choose
At the end of the day, the regular method will typically offer a higher potential tax deduction, especially with effective tax planning, but it will also require you to keep more detailed documentation. The simple method requires minimal effort and documentation. Is the higher potential deduction worth increased documentation requirements based on your situation?