We’re all looking for legal ways to reduce taxes and it’s common for one physician to hear another discussing certain ways to do so. Before you go buy a farm, cow, build a pool, or equipment for tax reasons, be skeptical and make sure to seek professional tax council to ensure their interpretation of the tax code is correct. These ideas are discussed in general terms over coffee in the break room and physicians don’t normally get much detail from those conversations, so I thought I’d provide some detail in this blog around one of the most common deductions brought up by my clients.
Physicians who use a portion of their home (for example, a spare bedroom) for business purposes may be able to deduct a portion of the expenses involved in maintaining that space. However, deductions for home office use have been controversial and challenged frequently by the IRS. The home office deduction is first computed on Form 8829, Expenses for Business Use of Your Home and would show up on Schedule C. If you’re an employee, this is reported on Schedule A of Form 1040. This is considered a miscellaneous itemized deduction, subject to the 2% of AGI limitation.
You’re entitled to this deduction if a specific portion of his or her residence is set aside and used exclusively on a regular basis as the principal place of the taxpayer’s work or business. For physicians, it’s rare that a space in your home is used exclusively for a trade or business. It may function as a place where you manage paying family bills, read, update your fantasy football picks for the week, and on occasion fill finish charts but it’s rare that it functions as a space exclusively used for a trade or business. If it isn’t used exclusively for your trade or business, you can still deduct direct expenses of operating a home business (office supplies, second phone line, depreciation on the computer, etc.), even if you do not qualify for the home office deduction. However, you will not be able to deduct for insurance, utilities, cleaning, and repairs. Home interest and property taxes will still be deductible from AGI as itemized deductions. I often find people are not using the space exclusively for business but are taking deductions for all the above, and unfortunately, they’re deducting more than the law permits.
The amount of the deduction cannot be greater than the gross income from the business activity conducted at the home office after reduction of the gross income by all deductible expenses of the business activity, whether or not associated with the home office. A carry-forward is provided for those deductions which are disallowed because they exceed the limit in a given year.
For tax years prior to January 1, 1999, a taxpayer must use a portion of his or her home exclusively and regularly for business purposes and also meet one of the following requirements in order to classify a portion of his her home as a home office:
1) A portion of the residence must be used as the principal location for a trade or business of the taxpayer
2) A portion of the residence must be used as a place to meet or deal with patients, clients, or customers in the normal course of a trade or business.
For tax years beginning on January 1, 1999, and thereafter, the definition of a principal place of business is expanded. The portion of the home used by the taxpayer for business purposes qualifies as a principal place of business under the following reasons:
1) A portion of the home is used by the taxpayer to conduct administrative or management activities of the taxpayer’s trade or business.
2) There is no other fixed location of the trade or business where the taxpayer conducts substantial administrative or management activities of the trade or business.
Before 1999, when a taxpayer only performed administrative/management duties related to his or her business from a home office, he or she was not considered to have passed the principal place of business test and, therefore, was not eligible to deduct home office expenses.
If you are an employee and not self-employed, the use of the home must be for the employer’s convenience.
If a separate structure is used that is not attached to the home, the use of that structure must be in connection with a trade or business (which is a less stringent requirement than the principal place of business).
In January of 2013, the IRS released Rev. Proc. 2013-13 giving taxpayers an optional safe-harbor method to calculate the amount of the deduction for home office expenses, beginning with the current tax year. Individual taxpayers who elect this method can deduct an amount determined by multiplying the allowable square footage (not to exceed 300 square feet) by $5. The maximum a taxpayer can deduct annually under the safe harbor is $1,500.
If you are not using the safe-harbor method, the calculation is as follows:
1. Determine the square footage of the area of the home used for the home office (i.e., 10’ x 15’ = 150 square feet in the spare bedroom)
2. Calculate the ratio of the home office to the rest of the home (i.e., 150/1,600 square feet total in the home = 9.375%).
3. Total the expenses for maintaining the home (i.e., utilities, insurance, property taxes, maintenance and cleaning, mortgage interest or rent, repairs, and depreciation).
4. Calculate the net income from the business operated in the home office, without any home office expenses.
5. Multiply the ratio in Step 2 by the interest and property taxes on the home.
6. Subtract the result of Step 5 from the result of Step 4.
7. Multiply the ratio in Step 2 by the total of the other expenses listed in Step 3, except depreciation.
8. Subtract the result of Step 7 from the result of Step 6.
9. Multiply the ratio in Step 2 by the depreciation calculated on the entire home (use a 39-year life because is considered a commercial building).
10. Subtract the result of Step 9 from the result of Step 8.
If the space in the home is not used exclusively for a trade or business, consider the amount of time you use the space for the trade or business. If you use the space 60% of the time to conduct business, you can still take depreciation on 60% of the cost of the computer printer, copier, desk, chair, and bookcases used in the office. You can also deduct cost of the business phone and office supplies.