Sole proprietors, including Real Estate Agents, who have a qualified home office have two options available to claim their deduction: The Simplified Method, and the Actual Cost Method. This article will introduce each method, share the basic rules that govern the home office deduction, and explain the Simplified Method.
The Simplified Method deducts a set amount per square foot of home office space. The deduction is easy to calculate and requires little recordkeeping.
The Actual Cost Method deducts expenses related to having a home office. This method requires the completion of a separate form (Form 8829), the categorization of direct and indirect costs, somewhat complicated calculations, and a great deal of recordkeeping.
Determining which method is best for you requires comparing the tax-savings each generates with the relative headache of using each method.
Basic Rules for the Home Office Deduction: Choosing between the Simplified or Actual Cost method is an annual election. Business owners are free to choose either technique each year. Once one is selected; however, it is irrevocable. When the tax return is filed with the IRS, the decision is final. If you later discover the other method would have saved more tax, you cannot change it on an amended return. You can, however, switch to that method on next year’s return without penalty.
Both methods require calculating and reporting both the size of the home office and the size of the home as a whole. The Simplified Method requires these measurements to be made in square feet. Although square footage is commonly used to calculate actual costs, alternative measures are allowed as long as they reflect the proportion of the home that is the home office. A home office can be a room in the home or a part of a room. When the home office is part of a room, such as a desk and filing cabinet in a guest bedroom, the size of the office includes the desk, filing cabinet and the immediate area used regularly and exclusively for business.
A home office can also be a separate building on the owner’s premises. When this is the case, the Simplified Method or the Actual Cost method can still be used. Calculating actual costs, however, may require some additional calculations depending on how costs are shared by the office and home as a whole.
We discuss the Actual Cost Method in another article. The remainder of this article will focus on the Simplified Method. You can also click here to learn more about the rules for having a qualified home office.
Simplified Deduction Method: The Simplified Deduction Method for the home office expense was introduced in 2013 as an alternative to the complex and error-prone Actual Cost Method. The Simplified Method’s calculation occurs on Line 30 of Schedule C (2018), Expenses for Business Use of Your Home, and does not require a separate form.
The Simplified Deduction allows sole proprietor Real Estate Agents to deduct $5.00 per square foot of qualified office space up to 300 square feet. As a result, the maximum deduction obtained from the actual cost method is $1,500 ($5.00 * 300 Sq. Ft).
For example, if your home office is 12 feet by 14 feet, the square footage of the office is 168 square feet (12 ft * 14 ft). Your (tentative) home office deduction is 168 sq. ft * $5.00 = $840. If, on the other hand, your office is 18 feet by 20 feet, its square footage is 360 square feet. Because the size of the office is greater than 300 square feet, your (tentative) deduction is limited to 300 square feet, or $1,500.
I use the phrase tentative when describing the simplified calculation because, as discussed in the Cons section below, the deduction is limited to business income.
Part-Year Calculation: If you use a home office for less than a full year, you are required to adjust your deduction. The adjustment necessitates prorating the office square footage (up to 300 Sq. ft) based on the portion of the year the office is used.
Jane, for example, has a 400 square foot office. She starts to use the office on September 1st for business and does so for the remainder of the tax year (September, October, November, and December) – Four months. Since her office is greater than 300 square feet, the deduction is limited to 300 square feet under the Simplified Method. Because the office was used part of the year, she must adjust her deduction using the following formula: (Square feet * # month) / 12 months.
(300 sq. ft. * 4 months) / 12 Months =
1200 / 12 = 100 Square Feet
Jane will be able to deduct 100 square feet the first year she used her home office for business. Her deduction will be 100 Sq. Ft * $5.00 per foot = $500.
Pros of the Simplified Method: There are several distinct benefits to using the Simplified Method. Here they are:
- Simplicity: The Simplified Method is easy to use. All you need is a measuring tape and the ability to prove that you have a qualified home office.
- Decent Deduction for Many: Real estate agents whose home offices are small relative to the size of their homes and those having no or little mortgage interest to deduct will often find the $5.00 per square feet deduction closely matching or slightly higher than the deduction provided by the Actual Cost Method.
- Less Risky: There is much debate as to whether the home office deduction is a red-audit-flag for the IRS, meaning that the IRS is more likely to audit returns claiming home office expenses. Regardless of one’s leanings in this debate, it’s a fact that auditors have a field day reviewing returns claiming the actual cost home office deduction. Why? Actual home office expenses, particularly on returns that are self-prepared, are often miscalculated. Additionally, many using the Actual Cost Method lack documentation to substantiate their deductions, making it an easy target for back-taxes and penalties.
- No Depreciation Required: The Simplified Method does not require depreciation of the home office. Unlike the standard mileage rate for vehicle use, no portion of the $5.00 per-square-foot deduction is deemed to be depreciation. The Actual Cost Method requires that depreciation be calculated and tracked each year.
- Mortgage Interest & Property Tax Unrestricted: No portion of the $5.00 allowed per home-office square foot is deemed to be Mortgage Interest or Property Tax paid on your home. So, if you itemize deductions on Schedule A, the Simplified Method does not require a reduction in the amount of Mortgage Interest or Real Estate Property tax claimed as itemized deductions. The Actual Expense method requires a reduction of these itemized deductions by any amounts claimed as home office expenses.
To summarize, The primary benefit of the Simplified Method is that it eliminates the effort and risk associated with the Actual Cost Method and Form 8829, Expenses for Business Use of Your Home.
Cons of the Simplified Method: There are a few drawbacks to the Simplified Method that can make it less appealing. Here’s a brief list:
- Cannot Create a Loss: The Simplified Method deduction is limited to tentative business income - it cannot create a loss on an agent’s Schedule C.
- No Loss Carryover: If the home office deduction exceeds tentative business income, the remaining expense is lost forever. It cannot be carried forward to the following year as it can under the Actual Cost Method.
- Lower Deduction for Many: Agents with home offices that utilize a higher percentage of their home’s living space, those with higher mortgage interest, and many who rent their home’s will find that the Actual Cost Method offers a substantially higher home office deduction than the simplified method.
Take Away: The Simplified Method for taking the home office deduction removes the risk, time, and recordkeeping required by the Actual Cost Method. The ease of the deduction, however, comes at a price for those who would receive a higher deduction from the Actual Cost Method. If your home office and household expenses run about the same every year, calculate the deduction using both methods and compare the result. If the Actual Cost deduction is higher than the Simplified deduction, consider the tax savings in light its complexity and recordkeeping requirements.
Summary and Invite: We hope this article helped you to understand the Simplified Method for deduction a home office. If you’d like to learn more about cutting your most significant expense, TAXES, check out our Real Estate Agent Tax Cut Library. The Real Estate Agent Tax Cut Library includes over eight hours of video broken into twenty-nine searchable volumes and covers every possible deduction a Real Estate Agent can take on their tax return. Our Broker Version will help your entire agency cut their taxes! We also invite you to browse our courses.