Covid and the Home Office Deduction

As many business owners and employees have begun working from home this year, what tax implications, if any, should we expect on our next tax returns?

One tax item you might have heard about is the “Home Office Deduction”.

First, the bad news: this deduction is not currently available to W-2 employees. So, unless you are self-employed (or a partner or member of an S corporation), this deduction is not available to you. This wasn’t always the case. Prior to 2018, this deduction was available as an itemized deduction if you worked from home as a requirement of your employer. But the tax reform known as the Tax Cuts and Jobs Act (TCJA) eliminated that option.

If you’re still reading, then perhaps you are self-employed or a full or part owner in a partnership or S corporation...or planning to fall into one of these categories in the near future.

Schedule C -Self Employed

Let’s start with the self-employed. You may have heard terms like “self-employed”, “sole proprietorship”, “single member LLC”, etc. all used interchangeably. That’s because they are basically the same from a tax perspective - the net income from your business activities are reported on your personal tax return (Form 1040) on Schedule C.

To qualify for the home office deduction on your schedule C, you must have a space in your home that is used “regularly and exclusively” to conduct business. The space does not have to be an “office”, it just must be off limits to any personal use. For example, you can, in fact, claim that a desk in your bedroom is your “home office”, BUT you would only claim the square footage that the desk utilizes, not the entire room. Space that is utilized for business storage may also qualify.

So, how is the deduction calculated?

There are two approaches. First, you can measure the “office” space (that desk in your bedroom) and calculate the percentage of that space as it compares to the total square feet of your home. Then you can apply that percentage to all of the shared expenses - electricity, heating/cooling, home insurance, mortgage interest (not the principal), real estate taxes, etc. If you have what are called “direct” expenses such as a separate installation of a business internet line or phone - that is used 100% for the business - you can deduct the full cost of those expenses.

The second option for the home office deduction is what’s called the “simplified option”. Basically, you just multiply the square footage of your “home office” by a given rate. Currently, that rate is $5 per square foot, up to 300 square feet. So, if you use 50 square feet of your home as your home office, you’re eligible for a $250 tax deduction.

Both methods above are limited to your business income, though. If you have a loss, then you cannot take the home office deduction. You may be able to carry over any disallowed expenses to the following year if you use the first method.

Now let’s talk about S Corporations and Partnerships.

The qualifications discussed above also apply to S Corporation owners and partners. But there are some special nuances if you fall under this category.

S Corporation Owners

Under this ownership structure, you may collect a paycheck from your S Corporation, but if you own more than 2% of the entity, special rules apply to you. This applies to all benefits, not just the home office deduction - but that’s for another day.

Expenses paid personally by shareholders are treated as “unreimbursed employee business expenses”. These expenses, as discussed at the beginning of the article, are no longer allowed as itemized deductions on your personal tax return.

Another option for shareholders, then, is to have the company “reimburse” your home office expenses. This must be done under what’s called an accountable plan. Under an accountable plan, an employee (or shareholder) can submit expense reports for certain expenses (maintaining adequate support/proof, of course) and the company can issue a nontaxable reimbursement. These reimbursements must be reasonable and necessary - read this as “No, you cannot receive a reimbursement for 100% of your home expenses.”

The reimbursable expenses should follow the IRS guidelines for the home office deduction - for example, determine the square footage of your business-only space and use this to allocate a percentage to your qualifying expense. The allocated expenses are what can be submitted to the company for reimbursement. Note that the “simplified method” can not be used in this case. You MUST use actual expenses.

Remember, though, at tax time, you cannot claim any expenses on your tax return that have been reimbursed. So, if you have received a reimbursement from the company for a portion of your mortgage interest, you cannot claim that portion on Schedule A of your personal tax return as you might normally do.

Partnerships

Partners

There’s a little added complexity to claiming personal expenses as a partner. You can use an “accountable plan” as described above to submit for and receive reimbursements from the partnership. Alternatively, a deduction for expenses related to a home office can be taken on the partner’s personal Schedule E. This must be specifically noted in the partnership agreement, though. These are called “unreimbursed partner expenses” (UPE). The agreement must state that the partner is required to pay the expenses personally, without reimbursement. Unlike the Schedule C home office deduction, though, expenses classified as unreimbursed partner expenses are NOT limited to the net income of the business.

Why can’t I just make my business pay me rent?

Well, the short answer is that you CAN have your business pay you rent. But the downside to this option is that you then must claim the rent as income. (And the IRS is keen to ensure the arrangement is legitimate.) So, ultimately, it may just be a wash with unnecessary complexity. There are instances when this rental agreement between an owner and a business may make sense, but all factors and the entire tax situation of both parties involved must be evaluated to determine the best course of action.

Conclusion

Hopefully, this article has been helpful as you navigate some of the tax complexities being presented to us in these changing times. Be sure to consult your tax advisor to determine the best path for you.