New Office in Home Rate

Under the guise of tax simplification, the IRS has provided an alternative to the current office in home deduction available to qualified employees and self-employed taxpayers. The Office in Home (OIH) deduction requires the taxpayer to have a dedicated space which is used only for the business. This rule hasn’t changed. You can read all the requirements on the IRS’s Office in Home page.

The new rules announced in Revenue Procedure 2013-13 will allow taxpayers to choose between a flat $5 a square foot deduction, capped at 300 square feet ($1500) and the traditional calculation starting on 2013 returns. Currently, the taxpayer is allowed to take a percentage, based on the ratio of office space to the total home space, of the expenses of maintaining the home. These expenses could include mortgage interest, taxes, insurance, utilities, rent, and repairs. If the home is owned, the taxpayer also takes a depreciation deduction for the space. Any expenses which are also deductible on the Schedule A (Itemized deductions) are pro-rated between the forms. It’s a complicated calculation and a set rate could be a good thing.

But the taxpayer or their tax pro needs to check both ways at least for the first year. It might not be advantages for someone with higher expenses or larger business areas. I could see where the traditional calculation would be better for a day care provider which uses a larger space. I also want to see the actual instructions for calculation the deduction because I have some questions?

First, what happens to the carry forward? Currently the OIH deduction is limited to the business income. It can’t put the business into a loss so once the business is at $0 income/loss any OIH deduction which is left over is carried forward to the next year. Will the new rate be allowed to carry forward?  I hope so but that cuts down on the simplified record keeping of the new rate.

Next, how will day care hours affect the use of the flat rate? In-home day cares not only use the square footage of the home used for business in their OIH calculation but they also modify that percentage based on their hours of operation. It’s not unusual for a day care to use 90% of the home. If they’re open 12 hours a day seven days a week, they will be able to take 45% of their home expenses for OIH. Will the new flat rate also have to be modified?

My other concern is the double dipping for some taxpayers who use the new flat rate. As mentioned earlier, the OIH deduction includes some of the same deductions as on the Schedule A. However, under the current system, the OIH percentage of those deductions is allocated first and the remainder is carried to the Schedule A. But under the flat rate, the taxpayer can use the OIH rate and take all their personal deductions on the Schedule A. Since the flat rate theoretically includes the mortgage interest, home taxes, and casualty losses in the $5 a square foot, the taxpayer would be using more than what they paid for those expenses. It might not be a big problem but it makes it important to check both rates to see which is better for the taxpayer.

The new Office in Home flat rate starts for 2013. That gives the IRS a chance for feedback and to create the actual procedures for implementing the optional method. If you are interested in commenting, the Revenue Procedure 2013-13 notice has all the info you need to do that.

Anthony answers some of my questions in the comments. Thank you Anthony!

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Comments

[Shirley Callahan, EA]

In update class today, instructor questioned the sale of home when 4797 asks for "depreciation allowed or allowable." What happens then?

[Anthony]

The revenue procedure states that no depreciation is allowable if you make the election. So that's another factor to consider.

As for still being able to take mortgage interest, real estate taxes, and casualty losses, I don't think the $5 a square foot does include these things. You'd have to get closer to the $8-10 a square foot range if you wanted to include that.

The strange thing is that the mortgage interest and real estate taxes are put on the Schedule A, not the Schedule C. So that's more factors to make sure to consider - the effect of the SE tax, the effect of maybe having a higher AGI but a lower taxable income, etc.

Looks like this is not only something that we're going to have to run both ways, but also something we should be discussing with the client. How much of a benefit is it to not have the unrecaptured section 1250 gains when you sell the house? Do you want to treat the SE tax as a loss, or do you want to factor in the increased social security payments you'll be receiving in the future?

As for your question about the carry forward, the Revenue Procedure states "Any amount in excess of this gross income limitation is disallowed and may not be carried over and claimed as a deduction in any other taxable year."

[Trish]

Anthony thanks for the clarification on depreciation and carry forward - Trish