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Published in Crain's Cleveland Business

June 24, 2013

Although the U.S. economy is showing signs of improvement, many individuals who lost their jobs over the past few years have turned to operating their own small businesses, often ones that can be operated out of their homes.

These taxpayers often seek to deduct expenses relating to maintaining the business in their home.

While this still can be a fairly complicated issue, the IRS announced earlier this year that it is making available a simplified option that owners of home-based businesses can use to figure their deductions for the business use of their homes.

While this “safe harbor” is optional, many business owners who use a home office will find this to be a significant time-saver. The IRS estimates that it will reduce the paperwork and record-keeping burden on small businesses by an estimated 1.6 million hours annually. The IRS's estimate of the time it takes to complete forms is usually low.

The IRS usually is not generous in allowing deductions relating to a taxpayer's use of his or her own home. The normal rule is that no deduction is allowed for expenses related to a dwelling unit that is used as a residence by the taxpayer during the taxable year.

A deduction is allowed, however, for expenses that are allocable to a portion of the dwelling that is exclusively used on a regular basis as the taxpayer's principal place of business or for meeting with clients or customers in the normal course of business.

A deduction is generally not allowed for an employee who uses a home office to get work done outside of normal work hours.

Use of a home for the purpose of storing certain inventory, providing day care and other specific uses are also permitted.

The home can be either owned or leased.

Even if a home qualifies for the deduction, taking the allowable deduction is not easy from an administrative standpoint.

At present, a taxpayer seeking to take a home office deduction is generally required to fill out a 43-line form (Form 8829), often with complex calculations of allocated expenses, depreciation and carryovers of unused deductions. Taxpayers taking the current allowable deduction also must comply with additional rules relating to record-keeping and substantiation of the deductible expenses.

The new option recently announced by the IRS provides eligible taxpayers an easier path to claiming the home office deduction, which may be claimed by completing a significantly simplified form.

The new optional deduction is calculated by multiplying the square footage of the space qualifying as a home office by $5. The allowable deduction under the safe harbor is capped at $1,500 per year, based on $5 per square foot up to 300 square feet.

The taxpayer can make the determination of whether to use the safe harbor on a year-by-year basis. The election to use the safe harbor is made simply by calculating the allowing deduction using the method described above.

Home office expenses can only be taken to the extent that the business produces income.

Taxpayers using the old method could carry the disallowed portion of the expenses forward to future years. Taxpayers using the new safe harbor method cannot carry forward any unused deduction.

If a taxpayer currently has a carryover of an expense from a year where the actual expenses were deducted, this carryover is not allowed in a year in which the taxpayer uses the safe harbor calculation.

The carryover amount can be used in any subsequent year in which the taxpayer reverts to the old method.

Homeowners using the new option cannot deduct actual expenses related to the qualified business use of the home for a year in which the safe harbor is used, including depreciation.

They can, however, claim allowable mortgage interest, real estate taxes and casualty losses on the home as itemized deductions as they would normally. These deductions need not be allocated between personal and business use, as is required under the regular method. Business expenses unrelated to the home, such as advertising, supplies and wages paid to employees, are still fully deductible.

The new safe harbor does not change the basic requirements for taking a home office deduction.

It is still the rule that a home office must be used regularly and exclusively for business, and the limit is still capped at the amount of income derived from the particular business. The safe harbor will still be a time-saver for most taxpayers who are able to claim this deduction.

Carl Grassi is president of McDonald Hopkins LLC.