In running my lean private practice, I use a shared workspace. This cuts down my expenses considerably. But I use the shared workspace only to see patients. I do all the administrative tasks related to my practice from home. So, I do a home office deduction every year. This way, not only am I saving money on office space but also making money on the tax deduction. I reached out to Johanna Fox Turner of Fox and Co CPAs, who is a long-time trusted sponsor of this site- both as a CPA firm as well as a wealth management firm– to write a guest post on this subject and she very kindly obliged. So, here goes:
A History of Home Office Deduction
Home offices are a contentious tax topic. There is a reason for that, but you must look back 30+ years to a 1991 audit of anesthesiologist Dr. Nadir Soliman’s home office deduction. The IRS denied it, the Tax Court overturned it, and the IRS scored a win in the Supreme Court. This was a big deal. As a result, older CPAs and younger CPAs who have been influenced by those older CPAs tend to shy away from the home office deduction, describing it as a “red flag” and “risky”. That’s usually all it takes for doctors to drop the subject and move on to safer areas, like deducting their new Tesla through their side hustle.
We at Fox are one of the lone voices crying out for more home office use on tax returns. Are we encouraging risky behavior by recommending that you deduct your home office? Only if you are not following the rules. Yes, Soliman lost in 1993 (it takes time to get through the Supremes).
However, the Taxpayer Relief Act of 1997 modified the law to allow business owners to deduct a home office if it is:
– Used by the taxpayer to conduct administrative or management activities of a trade or business, and
– There is no other fixed location of the trade or business where the taxpayer conducts substantial administrative or management activities of the trade of business.
Unfortunately, the Soliman case seemed to end the home office debate for most of the CPA profession, which isn’t known to pounce on radical tax-saving ideas. TRA 1997, however, truly opened the door to home office deductions for anyone who takes the time to do the work to track expenses and document their legitimacy.
With our history lesson concluded, I’m writing this post to help you understand and analyze whether you have – or can set up – a home office for your work so your tax preparer can make the appropriate choices at tax time.
Basic Requirements
To start, you must have a space in your home where you either:
– Conduct substantial administrative or management activities of your business and/or
– Run your business, meet patients/customers, etc.
This space is typically a separate room but can be a corner of a room bounded by furniture (ex: bookcases or couches). Specifically, you must designate this area as your office and it cannot serve a dual purpose, such as the dinner table, guest bedroom, or workout room.
If you do have a home office, you are allowed to deduct costs proportionate to the size of your home whether you rent or own. These expenses include utilities, insurance, repairs and maintenance, security, mortgage interest, real estate taxes, and depreciation
You also can deduct 100% of the value of any furniture or fixtures you “convert” to business use in your home office, such as a desk, couch, chair, lamp, etc. Fixing up expenses also are 100% deductible if solely for your office space. Examples are painting, flooring, new lighting, shades, etc. to enhance your office space.
Uses of a Home Office
I’ve been asked many times what doctors who don’t work from home need home offices for. Of course, you’ll have to consider what work you do at home, away from the hospital or practice, but a few examples are scheduling, reading charts, banking, bookkeeping, talking to patients, studying, online CE – however you need a private administrative space for work.
Home offices have become more popular with clients in the last two years as they take advantage of COVID-inspired telehealth. How the deduction flows through on your tax return depends on how your business is organized for tax purposes.
Business structures and Home Office Deduction
Sole proprietors
Most of our clients with home offices are unincorporated businesses or practices. Many have a side hustle taking extra shifts or doing locums, while others work locums full time and/or have established a practice with no employees. For their situations, we calculate the home office deduction on IRS Form 8829 and deduct it on IRS Schedule C, line 30.
Home offices not only reduce income taxes, but they also reduce FICA taxes and your AGI (Adjusted Gross Income) as an “above the line” deduction. Lowering your AGI is important because so many tax benefits are allowed, denied, or phased out depending upon your AGI amount.
Partners
If you have self-employment income from a partnership, you may qualify to deduct your home office (and other expenses) under UPE (Unreimbursed Partnership Expenses) guidelines. To qualify, you must be expected to personally pay certain partnership business expenses. Ideally, these expenses should be stipulated in the partnership agreement, but they can be deemed UPE by routine practice that is understood by the partners. UPE may include travel, your home office, paying a scribe, supplies, or any other unreimbursed partnership business expense.
In the 2011 McLaughlan case (affirmed upon appeal in 2014) the IRS denied over $100k in unreimbursed expenses. It should be noted that Mr. McLaughlan already had been reimbursed more than $60k annually by the partnership for each of the two years under audit. Based on this case, I would add that UPE taken should be reasonable and, of course, deductible in the normal course of business.
Pigs get fat and hogs get slaughtered.
UPE is deducted on Part II of Schedule E (page two) on a separate line below the K1 entry amounts for the related partnership. You should also attach a schedule detailing the list of UPE expenses for the IRS.
As with sole proprietorships, the UPE deduction reduces self-employment taxes.
S-corporation owners
If your business is taxed as an S-corporation, you are an employee and your out-of-pocket employee business expenses currently are not deductible.
Pretty abrupt, huh? Fortunately, it’s not quite that hopeless. The IRS has provided a workaround called an “Accountable Plan”, which we recommend to S-corp owner-employees.
Under an accountable plan, employers can reimburse employees for out-of-pocket business expenses such as mileage, meals, and maintaining a home office for the convenience of the employer. The employer gets the deduction and the employee gets reimbursed tax free. Yep, even though your money is only changing pockets, that’s how it works.
The two criteria owner-employees of S-corps need to meet are:
– Expenditures must qualify as business expenses (“ordinary and necessary”) and
– The expenses must be substantiated within a reasonable period of time (we use quarterly).
You, the employer, should document an agreement with you, the employee, detailing allowable expenses and the reimbursement process. I recommend you set up a template to organize the home office expense detail being reimbursed (we use Excel). It takes a little time to set up, but it’s easy to manage after that. If you are working with a CPA or other tax preparer, ask for help getting started.
A word about Simplified Home Office Method
There was much fanfare when the IRS rolled out the Simplified Home Office Method (SHOM) in 2013. I think CPAs were happy because they could finally shut up clients who kept bugging them about deducting their home offices and the IRS was happy because clients traded a higher deduction for an easier solution. As for the clients, they probably figured a skimpy deduction beat none at all. It was a win-win-win, or so it seemed.
The SHOM allows a business owner to deduct $5/sq foot for an office of up to 300 square feet for a maximum deduction of $1,500. This method disallows you from deducting depreciation (more on that next). We have exactly one client for whom this makes sense. Why, you ask? Because most physicians live in expensive homes and the depreciation can be rather high, not to mention utilities, insurance, maintenance, etc., especially if the home office is larger than a closet. Home office in a NYC co-op? Your deduction may be over $20k (ask me how I know). The decision to use SHOM is irreversible (you cannot amend to deduct actual expenses).
Depreciation recapture
Another reason CPAs give for discouraging the home office deduction is depreciation recapture. “Oh, you don’t want to deduct that! You might have to recapture all that nasty depreciation some day!” In my simple mind, deducting depreciation is a bird in the hand. All you’re doing when (if) you sell is paying tax on deductions that got you tax breaks in prior years.
Not to mention that…depreciation recapture is taxed at a top rate of 25%. In peak years, your home office depreciation deduction will save you 35% to 37% federal taxes + Medicare taxes of 2.9% + .9% for high earners. Why would you deny a tax deduction at 40% just because you might have to pay 25% on recapturing that deduction someday?
One last benefit
This is a quickie I’m throwing in: as you probably know, you cannot take an itemized deduction for interest on mortgage balances > $750k (loans taken out after 12/15/17). You also cannot deduct more than $10k of SALT (State And Local Taxes) on your schedule A.
But these expenses are not limited in your home office, so you are effectively able to deduct them (proportionate to your home office size) in addition to the schedule A limited amounts. There – not enough to convince you to set up a home office, but better than a sharp stick in the eye.
Should you deduct your home office? If you have a space that conforms to the above requirements, why not at least consider it? Again, it doesn’t matter whether you have a side hustle or full-time practice as long follow these guidelines.
Of course, the final choice is between you and your tax dude/tte. My wish as a CPA is that this post will, at a minimum, help you manage the forosophobia that you have lived with since becoming a fully-grown taxpaying member of our society and, perhaps, turn your home office into a productive, tax-saving area of your home sweet home.
I hope you found this post as useful as I did. I look forward to many more years of saving on the home office deduction. And if you have any questions regarding your personal or business taxes, check out Fox and Co as a reliable resource. Thank you for reading. Questions or comments, put them down here!