With tax preparation season well underway, it is a good time to examine the use of the home office deduction.
Often cited as a “red flag” for tax audits, the home office deduction is a legitimate business deduction particularly important for certain professionals and small business owners. Moreover – from the housing economics perspective – IRS data concerning the deduction, along with Census data reporting who works at home, can shed light on an important and growing role for homes: workplaces for business owners and telecommuters.
There’s no doubt that the practice of working at home is on the rise. Data from the Survey of Income and Program Participation shows that only 7% of workers (9.2 million individuals) reported working at home at least one day a week in 1997. By 2005, the share had grown to 7.8% (11.3 million) and reached 9.5% (13.4 million) in 2010—an 18% increase in just five years. What’s more, the most recent data from the Bureau of Labor Statistics suggests that 25.7 million people—or 24% of the workforce—performed some portion of their daily work at home on an average day in 2015.
The distribution of workers who primarily work at home (most days) shows clear geographic clustering. Using data from the 2015 Census Bureau American Community Survey, the map shown below exhibits the share of the workforce (age 16 and over) who report working at home. The highest shares are found in the West, Northwest, and New England. Colorado (7.1%) and New Hampshire (7.0%) lead the nation, while Mississippi has the lowest share at 2.2%.
The reasons behind this geographic distribution are not immediately clear. Potential explanations include the geographic distribution of jobs that are more likely to include or allow at-home employment, weather, age/education differences in the workforce, and less quantifiable differences in workplace culture across states. Regardless, the growth of working-at-home represents a business opportunity for both remodelers as well as builders to benefit from designing homes with this trend in mind.
Recent industry-specific IRS data (2014) for the home office deduction for independent contractors and sole proprietorships (not telecommuters) provides a sense of who is using space in their home for a dedicated office.
Unsurprisingly, workers in industries that require more individual independence or are reliant on technology, relative to other industries, tend toward greater use of the deduction. For example, educators, IT professionals, workers in professional services (lawyers, accountants, architects, etc.), and those in arts and entertainment are all more likely to claim the home office deduction. Real estate ranks 6th in terms of the value of the home office deduction relative to others, with many Realtors reporting home office expenses. Home office deductions are less common in the construction sector, although many small construction firms do have home office expenses.
Specific sectors with high levels of home office deduction use include:
- video/audio producers
- internet-based workers
- real estate brokers
- building inspectors
- management consultants
- social workers
- religious and professional organization workers
IRS data shows that a total of $9.5 billion in home office expenses (insurance, rent, repairs and utilities) were claimed for tax year 2014. The deduction is split into two classes: direct expenses related to the actual office and indirect expenses that apply to the entire home and are only partially deductible. Approximately 6 out of every 7 dollars claimed as a deduction relate to indirect expenses. An additional $1.2 billion in home office related depreciation deductions was claimed in 2014.
Taxpayers likely to claim the deduction, including small business owners (builders and remodelers) and Realtors, should be aware of the rules for doing so. The IRS has a good summary page on the deduction. More details can also be found in IRS Publication 587, which includes a flowchart (shown below) taxpayers should use to determine if their expenses qualify for the deduction.
From a tax law perspective, two relatively recent key changes are worth noting. First, the IRS provided a simplified method for claiming the deduction in 2013, which can save taxpayers time in filing the required form. Under this approach, taxpayers may claim a $5 per square foot of home office space (up to a maximum of 300 square feet). Other related expenses such as mortgage interest and real estate taxes are still claimed on Schedule A, and no depreciation deduction (including future recapture) is allowed.
Second, those worried about the historically strict tests connected to the deduction should be aware of tax law changes that went into effect in 1999. The Taxpayer Relief Act of 1997 clarified that a residence can qualify as a principal place of business when it is used to conduct administrative or management activities if there is no other fixed business location. However, homeowners as well as renters must use the office space exclusively used for business purposes.
Telecommuting employees are less likely to be able to claim the deduction (they must itemize, for example), and should consult IRS Form 2106 for additional detail to determine whether they qualify.
Finally, the IRS recently published IRS Tax Tip 2015-42 and more explanations on the simplified deduction method. The Tax Tip document provides 6 helpful points on the use of the deduction.