Home Office Deductions in the Time of Coronavirus
Making Sense of a Commonly Misunderstood Tax Deduction, with Policy Recommendations for Lawmakers and the IRS to Provide Additional Relief for American Taxpayer
Working from home has become the new normal for millions of Americans, and is likely to remain a fundamental aspect of American life even after the COVID-19 crisis begins to fade. In turn, American workers have been required to adapt their circumstances to the unique demands of working from home—setting up home offices, bearing the expense of increased utility bills, and devoting portions of their homes previously used for personal purposes to business use.
In the face of these new circumstances, many workers may wonder whether the costs associated with setting up and operating a home office are tax deductible. As is common for questions answered by federal tax law, the answers are less than clear and depend on the taxpayer’s particular circumstances.
Home Office Deduction: Background
As a general proposition, ordinary and necessary business expenses are deductible under Internal Revenue Code (IRC) § 162. Further, expenses incurred in the production of income are generally deductible under IRC § 212, and business-related expenses, such as depreciation, are deductible under different parts of the Internal Revenue Code. Conversely, expenses incurred in maintaining a personal residence, such as utility bills, general maintenance, and depreciation, are generally not deductible. However, when a taxpayer works from home, the line between business expenses and personal expense—that is, those expenses which are generally deductible and those which are not—becomes blurred.
In balancing these competing considerations, Congress has created a fairly complex set of rules which start with the presumption that expenses relating to the use of a “dwelling unit,” referred to herein as home office expenses, are not deductible, but which carve out important exceptions designed to prevent abuse while furthering the general policy of permitting deduction of business related expenses.
Before examining the rules governing home office deductions, it is important to note two items of particular relevance. First, the recently enacted CARES Act, known primarily for providing relief measures to individuals and businesses suffering from the COVID-19 crisis, does not directly affect the rules governing home office deductions. Thus, the pre-crisis rules still govern.
Second, in December 2017, the Tax Cuts and Jobs Act (TCJA) became law. One aspect of the TCJA was to eliminate miscellaneous itemized deductions for individual taxpayers for tax years beginning after 2017 and ending before 2026. Home office deductions under § 280A are miscellaneous itemized deductions for individual taxpayers who work as employees. Thus, under current law, individual employees are not permitted to claim home office deductions, but home office deductions are still available with respect to taxpayers who file a Schedule C with their 1040 to report the income and expenses of a sole-proprietorship. Similarly, the home office deduction is available to pass-through business entities, such as partnerships and subchapter S corporations. Given the renewed emphasis on at-home work (which in many cases is mandated by employers or State or local ordinances), it may be wise for Congress to revisit this limitation, at least for the 2020 and 2021 tax years. However, to date it has not done so.
IRC § 280A
Initially, in balancing between the general deductibility of business-related expenses and the non-deductibility of personal-use expenses, courts applied a relatively lax standard and allowed a deduction for business use of a home when the expense was “appropriate and helpful” to a taxpayer performing his job duties. See Newi v. Comm’r, 432 F.2d 998 (2d Cir. 1970). Fearing such a standard could lead to abusive behavior, in 1976 Congress passed IRC § 280A.
Section 280A does not itself authorize any deductions—it merely determines when otherwise deductible expenses (for example, those deductible under IRC § 162) may be deducted when those expenses relate to a taxpayer’s home. As noted, the general rule of § 280A is that home office deductions are not allowed. IRC § 280A(a). However, the statute contains key exceptions. Specifically, to qualify for the home office deduction under § 280A, a taxpayer’s home (referred to as a “dwelling unit” in the statute) must, on a regular basis, be used exclusively:
- As the principal place of business for any trade or business of the taxpayer
- As a place of business which is used to meet patients, clients, customers, etc. in the normal course of the trade or business, or
- In the case of a separate structure not attached to the taxpayer’s residence, in connection with the taxpayer’s trade or business.
Further, even if these requirements are met, there are limitations on the deductibility of a home office expense. First, only an allocable portion of the applicable expense can be deducted. After all, even if a taxpayer works from home, some portion of the expense is used for personal purposes and thus not deductible in any circumstance. Second, § 280A places a ceiling on the overall amount of a home office deduction. The rules relating to these limitations are discussed in more depth below.
We also acknowledge that there are special rules relating to rental homes and day care facilities operated out of a taxpayer’s residence, but given that both of those activities will be severely limited in the near future, we will focus in this article on the three primary exceptions listed above.
As a threshold matter, § 280A only applies to expenses incurred with respect to a dwelling unit which the taxpayer uses for personal purposes for more than 14 days in the given tax year. A dwelling unit includes a house, apartment, condo, mobile home, or similar structure, including all structures or other property appurtenant to the dwelling unit. For this purpose, personal use generally includes personal (non-business) use by the taxpayer, the taxpayer’s family members, or any other individual unless the dwelling unit is rented to that individual for fair value. Thus if the taxpayer’s home is used as a residence for personal purposes for 14 days or less during the tax year, the deductibility of any associated expenses are determined without reference to § 280A.
Finally, § 280A does not bar deduction of home-related expenses which are otherwise authorized under the Internal Revenue Code notwithstanding the taxpayer’s use of his home in his trade or business. For instance, the deductibility of mortgage interest is not affected by § 280A.
Home Office Deduction: Elements of Primary Exceptions to § 280A
Before a taxpayer may deduct home office expenses, the taxpayer must satisfy one of the enumerated exceptions to § 280A. The three primary exceptions listed above contain generally applicable requirements and specifically applicable requirements.
- Generally Applicable Requirements
For each of the primary exceptions under § 280A, the taxpayer’s home must be used in furtherance of a trade or business, and the portion of the taxpayer’s residence used for business purposes must be exclusively used, on a regular basis, for such business purposes.
- To be engaged in a trade or business, the taxpayer must be involved in the activity with continuity and regularity and the taxpayer’s primary purpose for engaging in the activity must be for income or profit. Comm’r v. Groetzinger, 480 U.S. 23 (1987). Note that a taxpayer may engage in multiple trades or businesses at the same time, and the taxpayer’s use of his or her home does not have to occur in connection with the taxpayer’s predominant business activity.
- For this purpose, regular use means frequent and repetitive use. Occasional or incidental use is not sufficient.
- With respect to exclusivity, while de minimis personal use of the allocated portion of the home may be allowed, the allocated space should be used exclusively for business purposes. For instance, if a taxpayer works from his or her dining room table but then later uses the dining room table for family dinner, expenses allocable to the dining room are not deductible. See Sengpiehl v. Comm’r, C. Memo. 1998-23. However, business-use space need not be clearly partitioned or separated from the residential portion of the property in order to give rise to a deduction, see Hewett v. Comm’r, T.C. Memo. 1996-110, although a clear partition is helpful in proving exclusivity.
As noted earlier, prior to the changes imposed by the TCJA, employees could potentially deduct home office expenses, but only if the home was maintained for the convenience of the employee’s employer. IRC § 280A(c). This was a fairly difficult standard to meet. Home offices which were merely helpful to the employer or employee were insufficient to meet this standard. Generally, in analyzing this question, courts have looked to whether a home office is required as a condition of employment, is necessary to the proper functioning of the business, or is necessary to allow the employee to perform his duties properly. Given the restrictions placed on businesses determined to be non-essential, it seems likely that many employees working from home due to the COVID-19 would be considered to be doing so at the convenience of their employer, but that issue is not settled. In the event Congress chooses to relax the limitations imposed by the TCJA and allow employees to claim deductions for home office expenses, this issue would likely be at the forefront of the § 280A issues posed by the COVID-19 crisis.
- Specifically Applicable Requirements
- § 280A(c)(1)(A)
- Specifically Applicable Requirements
Under § 280A(c)(1)(A), a home office deduction is available when the taxpayer’s residence is the principal place of business. In some cases, it is obvious that a taxpayer’s home is his or her principal place of business. For instance, if a taxpayer’s trade or business is operated entirely out of his or her home, the home will be the taxpayer’s principal place of business. More difficult questions arise when the taxpayer works inside and outside his or her home. In that circumstance, a taxpayer’s home can qualify as a principal place of businesses so long as the taxpayer uses his or her home to perform administrative or management functions, and there is no other fixed location where substantial management or administrative activities occur. Thus, if the taxpayer has a home office from which the trade or business is managed, and there is not another location from which substantial management or administrative functions are performed, he or she will be eligible for a home office deduction even if the taxpayer performs services outside the home. Administrative or management activities include billing, maintenance of books and records, ordering supplies, setting up appointments, and forwarding orders and writing reports.
Further, even if the taxpayer does not engage in substantial administrative or management activities at his or her home, the taxpayer’s home can be the principal place of business based on analysis which looks at the relative importance of the activities performed there and the amount of time spent there. Comm’r v. Soliman, 506 U.S. 168 (1993). This analysis requires an objective description of the business in question, and thereafter an analysis of where the business’s goods or services are delivered or rendered. If the business requires a specialized or unique setting outside the taxpayer’s home to complete its business goals, then it is unlikely the taxpayer’s home will be viewed as the principal place of business.
- § 280A(c)(1)(B)
If a taxpayer meets with clients or customers at the taxpayer’s dwelling, then the taxpayer can qualify for the home office deduction even if the taxpayer’s home is not the principal place of business. For instance, a doctor who sees patients from a home office could qualify for this exception. However, to date this provision has been interpreted to require in-person meetings. Telephone meetings are not sufficient. There does not appear to be any guidance regarding remote face-to-face meetings (e.g. via Zoom), but in ruling that telephone meetings are not sufficient the Ninth Circuit emphasized the need for clients to actually visit the home office. Green v. Comm’r, 707 F.2d 404, 407 (9th Cir. 1983). However, this issue has not been tested in these very unique circumstances in which face-to-face meetings are often prohibited, so the extent to which this exception to the general rule of § 280A will be available to taxpayers meeting their clients and colleagues from home remains an open question.
- § 280A(c)(1)(C)
Another possible basis to deduct home-office related expenses arises when the taxpayer maintains a separate structure not attached to his or her dwelling unit. In that circumstance, a home office deduction is allowable if the free-standing structure is used exclusively and on a regular basis in connection with the taxpayer’s trade or business. What distinguishes this exception from those discussed above is that the free-standing structure need not be the taxpayer’s principal place of business, nor does the taxpayer need to meet customers or clients in person to qualify of this exception.
Home Office Deductions: Limitations on Deductible Amount
In addition to the qualitative prerequisites to the home office deduction, there are two primary limitations on the amount of home-related expenses that may be claimed under § 280A. First, the expense must be allocable to the portion of the home used for qualifying business purposes. Second, § 280A caps the amount of the home office deduction at the amount of gross income generated by the applicable trade or business.
- Home Office Deduction Allocation
Taxpayers may use any method that is reasonable under the circumstances to allocate home-office related expenses between business and personal use. For instance, if the rooms in the taxpayer’s house are approximately equivalent in size, the allocation can be based on the number of rooms that qualify for the deduction under § 280A. Alternatively, the allocation can be based on the square footage of the home. The Tax Court has held that only functional space of the home needs to be included in the denominator of the relevant fraction; in other words, unusable portions of an attic or cellar are not included. Culp v. Comm’r, T.C. Memo. 1993-270.
Direct expenses, i.e. those that benefit only the business-use portion of the home, may be deducted in full. Conversely, indirect expenses benefit both the business-use and personal-use portions of the home (i.e. utility bills, real estate taxes, insurance, etc.). Indirect expenses may be deducted to the extent of the percentage of the home allocable to qualifying business use. For instance, if a taxpayer’s electricity bill amounts to $1,000 per year, and 10 percent of his home is allocable to qualifying business use, $100 is the allowable deduction under § 280A. Unrelated expenses are those which do not benefit any part of the home used for qualifying business purposes. For instance, if a taxpayer’s home requires kitchen repairs and the kitchen is not used in the taxpayer’s trade or business, those repair expenses are unrelated expenses. Unrelated expenses may not be deducted.
Alternatively, a safe harbor allocation method is available. Under the safe harbor method, the allocable square footage of the home (not to exceed 300 square feet) is multiplied by a pre-set rate (currently $5). So, for instance, if 150 square feet of the home is used for qualifying business purposes, the safe-harbor deduction would be $750.
- Limitations on Amount of Deduction
Even if a home-office deduction is permitted by IRC § 280A, the deduction is capped by the amount of gross income generated by the business for which the home office is used. A home office deduction therefore cannot create a net operating loss. Deduction of expenses relating to a qualifying home office requires several steps, which must be taken in order:
- First, home-related expenses, the deductibility of which is not determined by the existence of a trade or business (i.e. mortgage interest on the taxpayer’s principal residence, property taxes, etc.), must be allocated between business and non-business uses of the home. The amount of such items allocable to the taxpayer’s home office is deducted against the gross income of the qualifying business and reduces the overall gross income limitation. The balance is deductible in the ordinary course, without regard to § 280A. Thus, if a taxpayer paid mortgage interest of $5,000, and 10 percent of the taxpayer’s house is used for business purposes which allow for a deduction under § 280A, $500 (that is, 10 percent of $5,000) is deducted against the gross income of the qualifying business, and the applicable gross income limitation must be reduced by $500. The balance of the mortgage interest amount for that tax year, $4,500 may be deductible irrespective of § 280A.
- Second, expenses attributable to the taxpayer’s business activity but not attributable to the use of the taxpayer’s home are deducted against the business’s gross income, and thereby reduce the overall gross income amount against which home office expenses may be deducted. For instance, if the business spends $1,000 on office supplies during the year, such amounts are deductible business expenses generally but they are not attributable to use of the taxpayer’s home (they would have been purchased regardless of the existence of a home office) and therefore reduce the overall gross income limitation by $1,000.
- Next, expenses that would be have been deductible (for instance under § 162) had the activity giving rise to the expense not been conducted in the taxpayer’s home, but which do not require a basis adjustment (i.e. utilities, insurance, maintenance, etc. that relate to the taxpayer’s residence) may be deducted to the extent of the applicable gross income cap (gross income attributable to the home office business, reduced under steps one and two above).
- Finally, expenses that would be have been deductible had the activity giving rise to the expense not been conducted in the taxpayer’s home, but do require a basis adjustment (i.e. depreciation of the taxpayer’s residence) may be deducted to the extent of the gross income cap remaining after steps one to three, above.
- Remember that § 280A does not itself authorize any deductions—it merely determines when otherwise deductible expenses may be deducted when those expenses relate to a taxpayer’s home.
Home Office Deduction: Illustrative Example
Because of the various layers to the home office deduction, we will now use an illustrative example to help shed light on how the home office deduction might play out in the real world.
Suppose Taxpayer operates a consulting business from a home office. Taxpayer previously operated from rented space in an office building, but due to the COVID-19 crisis, by local ordinance his office is closed and he has been forced to work from home since April 1. Today, Taxpayer’s billing, record maintenance, and preparation of policies and related contracts—which were previously performed at his business office—are now performed from his home office. However, due to the COVID-19 crisis, Taxpayer does not meet with clients in his home office. Instead, all client meetings are attended remotely.
Taxpayer reports his income and expenses from his consulting business on a Schedule C attached to his Form 1040 each year.
Taxpayer’s home consists of 10 rooms of various sizes, and totals 3,000 square feet. Taxpayer’s home office occupies an entire room and comprises 300 square feet. Since the start of the COVID-19 crisis, Taxpayer’s home office is not used for any purposes other than Taxpayer’s consulting business. Previously it was used as personal storage space, but since the start of the year it had been empty until the Taxpayer began using it for his home office.
Due to concerns regarding the virus, and factors relating to convenience, the Taxpayer continues to work from his home office the rest of the year. At the conclusion of the year, gross income from the Taxpayer’s consulting business totals $10,000. Taxpayer also incurred the following home-related expenses during the year:
- Mortgage interest: $3,000
- Real estate taxes: $5,000
- Utilities: $1,000
- General business supplies: $1,000
- Homeowner’s insurance: $1,000
- Lawn care: $500
- Third-party answering service: $2,000
It is clear that the Taxpayer’s consulting business constitutes a trade or business. Further, his home office should qualify under the generally applicable conditions of §280A. Using a home office during business hours for 9 months of the year—that is, from April to December, should qualify as regular use. Further, based on these facts, the use will also likely be viewed as exclusive. While his home office space was not used for business purposes from January through March of the tax year, it was not specifically used for any personal purposes either—rather, it was empty. Had Taxpayer continued to use the space for personal storage purposes, it would be much more difficult to establish entitlement to a home office deduction because the business use of the room would not have been exclusive at all times during the tax year. See Prop. Reg. § 1.280A-2(g)(1).
The next step is to determine whether the Taxpayer’s business satisfies one of the three primary exceptions provided by § 280A. Under these facts, the only exception that could apply is the principal place of business exception—Taxpayer does not meet with clients in his home office, and there is no clear authority to date that says remote meetings are sufficient for client-meeting exception. Moreover, Taxpayer’s office is a room in his house and is not a free-standing structure. However, since he began utilizing his home office, all administrative and management activities have occurred there, and there is no other fixed location where substantial administrative or management functions occur. Consequently, the home office should qualify as the Taxpayer’s principal place of business—but only for three-quarters of the year. IRS Pub. 587 (2019) at p. 5 expressly states that partial year use of a residence for a qualifying purpose is sufficient to claim a pro-rata home office deduction.
Taxpayer also properly determines that 10 percent of his home is allocated to an excepted business used under § 280A(c). Allocating 10 percent of his home to business use is proper because 300 square feet out of a total 3,000 square feet are allocated exclusively for regular use in Taxpayer’s insurance business.
Because the Taxpayer used his home for a qualifying business purposes for only three-quarters of the tax year, the rules of § 280A will only apply to three-quarters of each item. This example assumes the expense items are evenly allocable to each month during the year (in reality, because expenses often vary month by month, a taxpayer must look to the expenses for each month his home qualifies for the home office deduction).
Of the expenses incurred during the year, mortgage interest and real estate taxes are generally deductible regardless of the business use of the home and thus fall under step 1, outlined above. However, 10 percent, or $600 (that is 10 percent of $8,000 x 75 percent), still needs to be allocated to the business-use portion of the home. Thus, $600 is deducted from the $10,000 of gross income generated by Taxpayer’s consulting business. he balance, $7,400, may be deducted by Taxpayer in the normal course, without regard to IRC § 280A. The overall gross income limitation on home office deductions is reduced by $600 to $9,400.
Next, expenses which are deductible but not related to home use must be taken into account. Here, that consists of the third party answering service utilized by Taxpayer’s business and the general business supplies. That $2,250 expense ($3,000 annual total x 75 percent) reduces the overall gross income cap to $7,150.
Next, the home office-related expenses must be allocated between business and non-business use. Here, those amounts consist of utilities and homeowner’s insurance totaling $2,000. After application of the allocation percentage, the deductible amount is $200 ($2,000 x 10 percent). Because Taxpayer’s home was utilized for business purposes during only three-quarters of the year, the deductible amount is reduced by 25 percent, down to $150. Because the remaining gross income cap ($7,150) exceeds the deductible amount ($150) the full $150 may be deducted against the business’s gross income.
The $500 of lawn care is not allocable to Taxpayer’s business use of his home, and is not otherwise deductible by his consulting business, and is thus not relevant to the analysis.
It is clear that § 280A, in its current form, fails to address many of the unique challenges posed by the COVID-19 crisis and the attendant changes to American work life. There are a number of steps Congress can take through legislation, or the IRS can take through the administrative process, even on a temporary basis, to provide relief to struggling American workers.
First, IRC § 67 can be modified so that the home office deduction is available to employees in tax years before 2026. As explained earlier, under current law the home office deduction is not available to individual employees due to the elimination of itemized deductions in the 2018 to 2025 tax years imposed by the TCJA. However, more than ever employees are working from their home offices and incurring increased expenses as a result. A temporary change to the deductibility of home office expenses (i.e. by expressly excluding qualifying home office expenses from the definition of “miscellaneous itemized deductions” under IRC § 67(b)) could generate larger refunds for millions of taxpayers and serve as an indirect economic stimulus.
Such a change could be supplemented with IRS guidance that making clear that employees who are required to work at home by their employers or pursuant to a federal, state, or local mandate precipitated by the COVID-19 crisis will be considered to be working at home at the convenience of their employers under § 280A(c)(1). Thus, taxpayers could be confident in claiming these deductions without the need to wait out the slow process through which tax statutes are interpreted by court decisions. These changes need not be permanent, and could be effective and provide relief even if implemented solely for the 2020 and 2021 tax years.
Moreover, the IRS could issue guidance clarifying that to the extent taxpayers typically met with clients or customers in a home office prior to the restrictions imposed by the COVID-19 crisis, continuing those meetings remotely (i.e. face to face, even if not physically in the same room) will not bar taxpayers from claiming a home office deduction under IRC § 280A(c)(1)(B), notwithstanding prior precedent that a taxpayer must meet with clients face to face in order to take advantage of the exception provided by § 280A(c)(1)(B).
FIDJ’s tax and tax litigation attorneys have extensive experience handling a wide variety of taxation matters for clients, both in and out of court. They will continue to monitor developments in this area of the law, and remain vigilant throuthout the Coronavirus public health emergency. If you have any questions, an attorney can be reached by emailing us at email@example.com or by calling 305.350.5690.