By: Ashley Hampton, MPA
2020 was an extraordinary and challenging year. In fact, a Stanford University study found that roughly 40 percent of the U.S. work force now works from home full time due to COVID-19. This has led many to question the effect this has on their taxes. Do you now qualify for the home office deduction? Did the CARES Act account for this wave of remote workers? Does my state follow the federal tax law? Continue reading to find your answers.
In 2017, the Tax Cuts and Jobs Act (TCJA) brought sweeping changes to the federal income tax law. One notable change was to the home office deduction. Prior to TCJA, W-2 employees could potentially receive a tax deduction for unreimbursed employee business expenses, including qualified home office expenses if they itemized their deductions and met the two percent (2%) adjusted gross income (AGI) threshold for miscellaneous expenses.
Under TCJA, miscellaneous expenses were suspended completely. In other words, the number of taxpayers that could benefit from the home office deduction was severely restricted. W-2 employees can no longer benefit from a federal home office deduction, even if their employer requires them to work from home. Instead, post TCJA, qualified home office expenses are only available for self-employed individuals or those who own partnership interests and use their home “regularly and exclusively” for business during the tax year.
GOVERNMENT RESPONSE CONSIDERING THE EFFECTS OF COVID-19
Unfortunately, there have been no revisions to the TCJA home office rules included in the 2020 CARES Act or the 2021 Consolidated Appropriations Act.
NOTE FOR OWNERS OF PARTNERSHIP INTERESTS
According to the IRS, partnership expenses are only deductible on a personal return if the partnership agreement expressly states that the partner must pay the expenses personally. Therefore, if you wish to take a home office deduction related to your partnership activity, be sure that your partnership agreement includes language stating that each partner must pay for these expenses personally without reimbursement.
CALCULATING THE DEDUCTION
Generally, home expenses must be categorized as direct or indirect when calculating the deduction. There is also an allowable simplified method to calculate home office expenses, which we covered in a prior blog.
Expenses that are directly allocable to the home office area – for example, repair and maintenance costs made in the home office – are fully deductible up to the business income limitation.
Indirect expenses need to be allocated between personal and business use and are also subject to the business income limitation. Some examples of common indirect expenses include property taxes, rent, depreciation on a home you own, homeowner association fees, utilities, and casualty insurance premiums. A reasonable method of allocation must be used. While a ratio based on square footage of the home office vs. the total home is the most common method, the number of rooms used for personal vs. business use has also been allowed.
Business Income Limitation
The home office expense deduction is limited to the gross income generated by the activity the home office is used for. This is known as the business income limitation. Deductions that are limited can be carried forward subsequent years.
Other Important Information
While the home office can provide a great tax deduction, taking this deduction could have a tax impact when you sell your house. When using the actual home office deduction method, you will have to pay a capital gains tax on the depreciation deductions for the office, whether or not you actually deducted depreciation each year. This is the annual deduction you are allowed for the yearly decline in value due to wear and tear of the portion of the building that contains your home office. These recaptured deductions are taxed at a 25% rate (unless your income tax bracket is lower than 25%). The amount subject to recapture will not be considered in your primary residence sale exclusion.
DOES YOUR STATE FOLLOW THE FEDERAL HOME OFFICE DEDUCTION RULES?
Despite employees not being able to deduct home office expenses for federal purposes, state treatment may vary. Each state and local jurisdiction’s rules about unreimbursed employee business expenses should be reviewed since the nature and allowance of the deduction may differ.
Pennsylvania allows certain deductions on PA Schedule UE as unreimbursed business expenses. These expenses must be actual expenses (not estimated), reasonable, necessary - a condition of employment (not a convenience), ordinary expenses that are directly related to the business, and were not reimbursed. Examples of some acceptable deductions are union dues, professional license fee, and office work area expenses (must be principal place of work). Pennsylvania allows any of these allowable deductions for any type of compensation and is not limited to self-employed individuals.
Philadelphia did not follow the federal change under the TCJA, therefore, any unreimbursed business expenses are allowed as a deduction from compensation if the expenses are ordinary, necessary, and reasonable. These expenses are allowed for any type of compensation and are not limited to self-employed individuals. Philadelphia does not have its own form to report these expenses, it utilizes Pennsylvania’s Schedule UE to document allowable deductions. You should attach this form to any refund claim you submit to Philadelphia and mark “Philadelphia – Deductions for Expenses Directly Connected with Employment” on the top of the schedule.
The coronavirus pandemic has undeniably changed our lives and made working remotely the norm for the foreseeable future. Talk to your tax advisor to help determine how or if the home office deduction applies to you and your situation.