Tuesday, September 29, 2009

A HOME OFFICE STANDARD DEDUCTION

Several of my fellow tax-bloggers and “tax twits” have discussed the recently re-introduced Home Office Tax Deduction Simplification Act (H.R. 3615), which “would allow business owners the option of a $1,500 standard deduction, but would not preclude taxpayers currently qualifying for the home office deduction from continuing to itemize their expenses should they choose”.

This issue came up back in January 2008 when National Taxpayer Advocate Nina Olsen submitted her annual report to Congress, which included a recommendation for a Home Office Standard Deduction.

At the time I wrote a post on the topic in my now-defunct companion blog for Schedule C filers THE FLACH REPORT. Here is what I wrote at the time:



One of the 11 legislative recommendations is to create an optional “standard home office deduction”. I quote below from the actual report:

According to US Census date, between 1999 and 2005 the number of home offices used exclusively for business increased approximately 20 percent. In addition, it is estimated {by the Small Business Administration – rdf} that slightly over half of small businesses are home-based, yet many of the business owners do not take the home office deduction. Of the nearly 20 million Schedule C filers in tax year 2003, approximately 2.7 million claimed the deduction. At the same time, 8.4 million respondents to the federal government’s American Housing Survey for the United States in 2003 indicated they had one or more rooms used only for business. Although the figures are derived from different sources and cannot be accurately compared, the data does raise questions about whether eligible taxpayers are taking the deduction.

Private industry has claimed that Form 8829 is too complicated and the rules regarding the home office deduction are too complex. The National Association for the Self-Employed (NASE) stated in 2005 testimony before the House Committee on Small Business that ‘many home-based business owners do not make use of the home office deduction due to the complexity of the deduction and stringent criteria they must meet’. In addition, a 2006 survey conducted by the National Federation of Independent Business (NFIB) Research Foundation found approximately 33 percent of small-employer taxpayers try to understand the tax rules governing home office business deductions, but only about half of those respondents believe that they actually have a good understanding of the rules. Further, in a member survey conducted by the National Association for the Self-Employed in March 2006, 72 percent of respondents favored the simplification of the home office deduction.

In July 2005, the IRS Office of Taxpayer Burden Reduction (OTBR) established a team with members from several IRS functions to address simplification of the home office deduction as a Burden Reduction Project. The project team recommended that the IRS issue guidance announcing an optional standard rate per square foot as an alternative for Schedule C, F, and A filers, and that the IRS develop a worksheet in the instructional booklet so that taxpayers no longer need to complete a separate form. The proposed standard rate would include factors for mortgage interest and real estate taxes (or a rent equivalent), utilities, repairs, maintenance, and home insurance. OTBR was flexible about whether or not the rate should include either a mandatory or optional factor for depreciation. If the rate does include depreciation, the associated worksheet would have a separate line indicating the depreciation portion of the deduction to assist the taxpayer in tracking depreciation for recapture purposes.

To alleviate taxpayer burden associated with complexities in reporting the home office deduction, the National Taxpayer Advocate recommends that Congress amend IRC 280A to provide an optional standard home office deduction. All taxpayers eligible to take the home office deduction pursuant to the requirements set forth in IRC 280A(c) would have the option to use a standard rate in determining the deduction to include on either Schedule A, C, or F of Form 1040. The applicable standard rate would be multiplied by the allowable square footage of the home office.

In calculating the standard rate, the IRS would need to break down the rate into component parts. The recommended deduction worksheet would also need to separately state the amounts allocated to several types of expenses in order to reduce the burden on the taxpayer. The components that must be clearly identified are real estate taxes, mortgage interest, and depreciation.

In the interest of simplification, a taxpayer should not be allowed to switch back to the actual expense method once he or she elects the optional standard home office deduction. However, if a taxpayer who has elected the standard deduction incurs disaster-related expenses in a particular year, the taxpayer should be allowed to include those expenses as part of the home office deduction.”

While I generally welcome with open arms any proposed simplification of the Tax Code, and the creation of a “standard home office deduction” would simplify the Code somewhat, I do not believe that such a creation would solve the problem of under-utilization of the home office deduction.

I do agree with Nina that many taxpayers who are entitled to the home office deduction are not claiming it, and that this is mostly Schedule C filers. I do not, however, think it is because Form 8829 is too complicated. The form is well constructed and flows quite nicely in identifying the components of the home office deduction. I find the form quite easy to follow and prepare – but then I am a tax professional and have prepared dozens of Form 8829s over the years. And if a Schedule C filer used a competent tax professional the “ease” of the form would not be an issue.

I think that qualifying sole proprietors and one-man LLCs do not claim the home office deduction because they are confused by the requirements and because they are afraid that claiming the deduction will raise a huge red flag on their return, and think that claiming it will mean an automatic audit. As I said in a previous post, it is my belief that a home office is no longer the red flag item it used to be.

The requirements for being a “principal place of business” were made more simple in 1997 with the expansion of the definition to include “used exclusively and regularly for administrative or management activities of your trade or business and you have no other fixed location where you conduct substantial administrative or management activities of your trade or business”.

Schedule C filers are also afraid to claim the deduction because they think that if they do they will have to pay federal and state income tax on the home office percentage of the gain on the sale of their home. Again, this rule was changed in 1997 and no longer applies. Homeowners only have to pay tax on the depreciation claimed on the home office after May 6, 1997.

The problem is that, as with any dramatic change in a long-standing tax rule, many taxpayers still think that the old rules still apply. I have found this to be especially true with the rules regarding the sale of a personal residence – many taxpayers still think they have to “buy up” when they sell their home.

A standard home office deduction would not change the above fears or confusions. Small business owners need to be educated about the correct existing home office rules. This is all the more reason that Schedule C filers should use a competent tax professional to prepare their 1040.

Replacing Form 8829 with a worksheet would not really simplify the process. One would still need to separate the deduction into three identifiable categories - real estate taxes and mortgage interest, general maintenance and upkeep, and depreciation. And I did not read anything in the report that would change the law regarding the income limitations on general maintenance and depreciation expenses. So carry forwards would still have to be calculated and maintained where the deduction exceeded the net Schedule C income.

Any standard per square-footage deduction rate would be based on national averages, and ultimately discriminate against geographic regions with substantially higher expenses – such as the Northeast (my area) and California, where real estate taxes and other expenses such as rents, insurance and utilities are much higher than in the rest of the country. Taxpayers in these areas would probably do better by claiming the actual expenses – so the standard deduction would not be of any benefit to them.

As for depreciation, I am conflicted about making it optional under a standard deduction. While I see that if there is no depreciation deduction there is no recapture down the road, which could certainly reduce future agita, I also feel that by not claiming the deduction I would not be doing my “duty” to provide my client with a return that produces the least amount of federal and state income tax liability possible. It would really depend on the individual facts and circumstances, though I would probably choose to adopt the “when in doubt defer” rule and claim the depreciation. I would much rather have Congress do away altogether with the deduction for depreciation of real property, as I have discussed in a THE WANDERING TAX PRO posting, than have the deduction made optional. .



Looking back on the post I find that my opinion on the issue has not changed, and I still stand by what I said back in January of 2008.

So what do you think about the idea?

TTFN

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