Decision Vision Episode 96: Should I Take a Home Office Deduction? – An Interview with Matthew Steinberg, Brady Ware & Company
The question of a home office deduction has suddenly come up in 2020 with so many more individuals working from home. Brady Ware Tax Manager Matthew Steinberg joins Host Mike Blake to discuss the eligibility factors for a home office deduction, how it is calculated, and more. “Decision Vision” is presented by Brady Ware & Company.
Matthew Steinberg, Brady Ware & Company
Matthew Steinberg specializes in tax and business advisory services, with an emphasis in tax compliance. He also has experience in a variety of areas, including high net-worth individuals, trusts and estates, private foundations, and tax planning. He has over eight years of experience in public accounting and focuses on providing high quality service to his clients.
Matthew is a licensed CPA in the state of Georgia. He is an active member of the America Institute of Certified Public Accountants and the Georgia Society of Certified Public Accountants. In addition to daily responsibilities, he serves as one of the firm’s liaisons at Tech Alpharetta, providing business support and tax advice to start-up technology companies.
He is also involved with the firm’s recruiting efforts at universities, and he attends on-campus events to meet with current students and discuss the opportunities a career in accounting can provide. Matthew is also an active member in his community and volunteers with the nonprofit organization All About Cats.
Mike Blake, Brady Ware & Company
Michael Blake is the host of the “Decision Vision” podcast series and a Director of Brady Ware & Company. Mike specializes in the valuation of intellectual property-driven firms, such as software firms, aerospace firms, and professional services firms, most frequently in the capacity as a transaction advisor, helping clients obtain great outcomes from complex transaction opportunities. He is also a specialist in the appraisal of intellectual properties as stand-alone assets, such as software, trade secrets, and patents.
Mike has been a full-time business appraiser for 13 years with public accounting firms, boutique business appraisal firms, and an owner of his own firm. Prior to that, he spent 8 years in venture capital and investment banking, including transactions in the U.S., Israel, Russia, Ukraine, and Belarus.
Brady Ware & Company
Brady Ware & Company is a regional full-service accounting and advisory firm which helps businesses and entrepreneurs make visions a reality. Brady Ware services clients nationally from its offices in Alpharetta, GA; Columbus and Dayton, OH; and Richmond, IN. The firm is growth-minded, committed to the regions in which they operate, and most importantly, they make significant investments in their people and service offerings to meet the changing financial needs of those they are privileged to serve. The firm is dedicated to providing results that make a difference for its clients.
Decision Vision Podcast Series
“Decision Vision” is a podcast covering topics and issues facing small business owners and connecting them with solutions from leading experts. This series is presented by Brady Ware & Company. If you are a decision-maker for a small business, we’d love to hear from you. Contact us at firstname.lastname@example.org and make sure to listen to every Thursday to the “Decision Vision” podcast.
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Intro: [00:00:01] Welcome to Decision Vision, a podcast series focusing on critical business decisions. Brought to you by Brady Ware & Company. Brady Ware is a regional full-service accounting and advisory firm that helps businesses and entrepreneurs make visions a reality.
Mike Blake: [00:00:20] Welcome to Decision Vision, a podcast giving you, the listener, clear vision to make great decisions. In each episode, we will discuss the process of decision making on a different topic from the business owners’ or executives’ perspective. We aren’t necessarily telling you what to do, but we can put you in a position to make an informed decision on your own and understand when you might need help along the way.
Mike Blake: [00:00:41] My name is Mike Blake, and I’m your host for today’s program. I’m a director at Brady Ware & Company, a full service accounting firm based in Dayton, Ohio, with offices in Dayton; Columbus, Ohio; Richmond, Indiana; and Alpharetta, Georgia. Brady Ware is sponsoring this podcast, which is being recorded in Atlanta per social distancing protocols. If you like this podcast, please subscribe on your favorite podcast aggregator and please consider leaving a review of the podcast as well.
Mike Blake: [00:01:07] So, today’s topic is different from what we normally do. If you’re a regular listener of the podcast, you know that although this podcast is being supported by a public accounting firm, we don’t often talk about accounting specific topics. And I don’t think I have to explain why. In fact, I think it may have been more than a-year-and-a -half since we did the last one. But there’s a topic that’s particularly topical that I want to make sure we cover. And we need to make sure that we cover it before the end of the year, because if we wait until after the end of the year, there may be some issues that may be too late for you to take action with.
Mike Blake: [00:01:57] And so, that topic is, Should I or can I deduct my home office expenses from my taxes? So, spoiler alert, the pandemic happened. A lot of us were sent packing. I mean, some of us are still in the office, but a lot of us have been sent home. And we’ve basically been told by our bosses that, you know, you can work anywhere you want, but you can’t work here. And that has created all kinds of challenges, as are well-known. There’s the general upheaval of simply working in a new environment. You’re probably, at least, initially, you were working in a setup that wasn’t geared towards work. You may not have the infrastructure that you had at the office.
Mike Blake: [00:02:44] And we had Jason Jones on a while back to talk about kind of the decisions that go around working from home and how to meet some of the challenges. And even a little bit of insight as to what the post-coronavirus real estate and office market may look like, if there’s a post-coronavirus. This may be something we live with. We’ll just have to figure that out.
Mike Blake: [00:03:05] But a question that I hear asked a lot – and I think if you’re not asking about it, you should – is, you know, now, that I’m working from home, are there any tax benefits to my doing so? I’m investing in resources and equipment and supplies. I, otherwise, would not have done unless I had been basically compelled to do so, whether it’s by the company, or a localized stay at home order, or some other force that required you to do that.
Mike Blake: [00:03:40] And as you guys know, I’m not a CPA. I’m not an account. The last thing I will do is give accounting advice or tax advice. The second last thing anybody else should do is take my advice if I offer it. So, what I’ve done here is, we’ve brought on an expert on the topic to help us kind of work through that. And there are really kind of a couple of, you know, key questions. One, can you deduct it at all? And number two, should you deduct it? And what I mean by that is, when you get into kind of high level taxes, there are deductions that you’re allowed to take and the IRS looks at, “It’s okay. That’s a deduction.” There are other deductions you take and the IRS looks at it and say, “Wait a second. We need to take a closer look at this here.” And so, you know, not everybody necessarily takes every deduction that is available to them because they don’t necessarily want to have the additional scrutiny on their finances, on their taxes. So, we’re going to talk a little bit about that balancing act to the extent that it plays out here.
Mike Blake: [00:04:51] And so, joining us is our very own Matthew Steinberg, who’s a manager at Brady Ware out of the Alpharetta office. Matthew specializes in tax and business advisory services with an emphasis on tax compliance. He also has experience in a variety of areas, including high net worth individuals, trusts and estates, private foundations, and tax planning. He has over eight years of experience in public accounting and focuses on providing high quality service to his clients. Matthew is a licensed certified public accountant in the State of Georgia. He’s an active member of the American Institute of Certified Public Accountant and the Georgia Society of Certified Public Accountants.
Mike Blake: [00:05:29] In addition to daily responsibilities, he serves as one of the firm’s liaisons of Tech Alpharetta, providing business support and tax advice to startup technology companies. Matthew is also involved with the firm’s recruiting efforts at universities, and he attends on campus events to meet with current students and discuss the opportunities a career in accounting can provide. Matthew is also an active member in his community and volunteers at the non-profit organization, All About Cats. I presume that’s not about the play. Matthew Steinberg, welcome to the program.
Matthew Steinberg: [00:05:58] Yes, it’s not about the play. Thank you for having me, Mike. A pleasure to be on here. You did mention the cat thing. I have a cat, literally, sitting next to me. One of the benefits from working from home, our animals get to enjoy us most of the day now instead of just a third or two thirds of the day, because our home is our office now. And it’s great that we are talking about that today.
Mike Blake: [00:06:22] Well, they do get to enjoy us. And I have two cats as well. I’m convinced they also mess with us, that they know when they don’t want us on the desk, when we don’t want them on the camera. And that’s exactly when they feel like they need to be there.
Matthew Steinberg: [00:06:37] Well, I hope my cat doesn’t walk over and step on the power button while we’re doing this, because that would just cause all kinds of issues.
Mike Blake: [00:06:45] So, Matthew, let’s jump in. You know, who is eligible for writing off a home office or workspace? Can employees do so or only the self-employed? Or is it more complicated than that?
Matthew Steinberg: [00:07:00] That’s a great question. So, currently, the way the tax laws are written, the only people who are really eligible for these deductions anymore are going to be people who are self-employed. The tax law was changed at the end of 2017 with the Tax Cuts and Jobs Act, which eliminated the ability for W2 employees, like you and me, to be able to deduct those expenses. And they were limited as an itemized deduction. I won’t get into the detail, but the IRS and Congress did away with that at the end of 2017, implemented in ’18. So, right now, the only people who are really eligible are those who can consider themselves self-employed or maybe they are partners in a partnership or something to that extent. Those are the people who are going to be eligible, not W2 employees.
Mike Blake: [00:07:54] Okay. And that part of the TCJA really didn’t get a lot of publicity, I don’t think. I think they’re much higher profile elements to that bill, that law. And probably we may not even be thinking about it all that much except for the fact that we have coronavirus.
Matthew Steinberg: [00:08:16] That’s right. Yeah. You know, it wasn’t really something that was being utilized that much, even by W2 employees. It’s always been a bigger bang for your buck and benefit for the self-employed individual. But there were certain people who did qualify. So, you’re exactly right that it wasn’t really publicized like some of the other items that were in that tax bill.
Mike Blake: [00:08:40] Okay. So, first decision point here, are you an employee? If yes, the answer is you’re not going to be eligible. So, I’m going to save you the rest of the 45 minutes, you could probably turn us off and go listen to something else. Listen to other fine podcasts at a podcast aggregator near you. Now, for the rest of us that are self-employed or, I guess, are in a less conventional job market, maybe you’re in a partnership and so forth, are there requirements out there for making a home office deduction? In other words, you know, a lot of IRS rules, as I understand it, have certain tests that will help you determine whether or not you are, in fact, eligible for that deduction. Is there a test of that kind for deducting home office expenses?
Matthew Steinberg: [00:09:33] Yeah. I mean, it’s a pretty standard tests in terms of it’s pretty black and white, which, you know, not a lot of items are with the IRS. Do you have a dedicated space in your home? Or, not necessarily in your home. Do you have a dedicated space that you’re using to operate your business? If the answer to that is yes, then you look to the next step, are you regularly using that space? And, say, you have two offices, say, you have a main office and then you have an office in your home, you are allowed a deduction or a potential for a deduction, even if you have two offices, as long as you can substantiate that you regularly use your home office as a place of business. So, those are pretty much the two generic standards in order to see if you would even qualify and then you move on to the next step at that point.
Mike Blake: [00:10:24] So, you said something I want to pause on. You said substantiate, what in the IRS would constitute sufficient substantiation that that space is indeed a workspace and not something else?
Matthew Steinberg: [00:10:42] I mean, that’s a good question. I mean, you know, the IRS is not going to come and knock on your door and say, “Hey, let me see your home office.” Unless you’re under some complete audit and they’re examining certain things like that. But you just need to be able to prove, you know, “Here’s my house. Here’s a room I have for it.” You don’t necessarily need a blueprint of the space. But all of that, in terms of substantiating and providing sufficient data or information related if you qualify, you know, that’s something you just need to feel comfortable about. If you have a space in your house, you have a room that you say, “Okay. This is where I do my office.” Or, “This is dedicated to it.” If the IRS ever came knocking on my door, which they don’t typically do, if they did, here’s the space and there’s the proof. That’s pretty much the basics behind it.
Mike Blake: [00:11:40] So, assuming you’re in a non-audit situation, you know, do you basically just say, “Hey, look. Our house is 2,000 square feet. We’re using 500 for the office.” And, therefore, you just sort of multiply it by your rent or by, I guess, your mortgage or something, maybe your depreciation and that’s it. And then, you might be asked to do more if the IRS decides to fly you and ask questions.
Matthew Steinberg: [00:12:07] That’s right. Yes. You’re getting into the detail. So, for example, say, your house is 2,000 square feet, like you said, and, say, your home office is 400 square feet. So, quick math, that’s 20 percent. So, if you’re thinking about expenses and things like that, getting into the depreciation, where you’re deducting part of your value of your home as an expense for your business, you’re going to take the percentage that’s related to your home office and things like that. We can get into the expenses and what are considered write-offs. You know, you mentioned mortgage interest and, I think, maybe real estate taxes, a percentage of that could be deductible against your business expenses if you’re a self-employed individual or a home office deduction. So, those are all very good points that you made.
Mike Blake: [00:12:54] What about job search expenses? You know, I haven’t looked at this because, fortunately, I have not been in a job search. But, historically, job search expenses have been something that one can write-off. If you have a dedicated space for your job search, a home office, could that potentially be a write-off opportunity as well?
Matthew Steinberg: [00:13:18] So, that’s a good question you asked. The job search expenses, those kind of went away with the TCJA, especially if it’s for, like, searching for a job, for an employment where you would be a wage worker. Those would fall under the two percent miscellaneous itemized deductions on Schedule A. But you do bring up a good point, say, you’re working for gigs and you’re an independent contractor, and you have a home office space. And you’re spending time searching for opportunities to get jobs, not necessarily employment jobs, but jobs where you get paid out of a 1099 or as a miscellaneous contractor. Then, you could qualify and substantiate some of those expenses related to a home office. But if it’s for job fulfillment related to getting a full time employment position where you’re paid a salary every week or every other week, then that wouldn’t qualify. So, it goes back to what we started with at the beginning, if it’s related to self-employment versus being a wage employee.
Mike Blake: [00:14:17] Okay. Now, for some of us, like me, the workspace is a part of the home. In my case, it’s sort of semi-detached. It’s part of the building, but you have to leave and then come back in, which is great. It means that barrier to entry means I don’t get bothered as much. But, you know, some people might have a garage, or a bar, and a workshop, a shed that’s actually a secondary freestanding structure. Does the concept or the approach to deduction change if it’s a freestanding structure? Does that make it easier, harder, no difference?
Matthew Steinberg: [00:14:57] Yeah. That’s a good point. You know, if you can designate a space that maybe isn’t part of your home, maybe it’s a separate space and you can assign value to that potentially, then it wouldn’t necessarily make it more complicated to compute the deduction. It would just be a different sort of calculation. But you’d still be eligible if you had a detached garage or a barn or shed you’re using that isn’t part of the house, that one unit of the house, you’d still be eligible for the deduction as long as you are regularly using it and conducting business there. So, that would qualify.
Mike Blake: [00:15:35] Okay. I actually know somebody who built a shed, a so-called she shed, on their backyard. And I know that that is exclusively for office use. If you do that, does the way deductions work, does that work any differently? Do you then, basically, have to depreciate the house? Is that how that works? Or can you deduct it all in the first year as an expense? Do you have any insight into how something like that might work?
Matthew Steinberg: [00:16:05] Sure. So, if you build, we’ll call it, a she shed – I don’t know what the use is – but if it’s for a business purpose and you’re generating income regularly from the use of that shed, potentially. Say, it cost them $30,000 to build it, you can easily compute that number because you had to come out of pocket for that amount. You sound like you have to break it out of anything or segregate it.
Matthew Steinberg: [00:16:33] In terms of deducting it, you could not expense it all in year one because it qualifies under the real property statute. So, if it’s being used for business, it would be depreciated over a long period of time. Thirty-nine years is the typical standard of life for a standalone building that’s used for commercial reasons. So, if it costs you 30,000 and you divide that by 39, it’s going to take you a pretty long time to realize that fact. So, it’s a slow process, but, you know, 100 percent of that would be related to the business because that’s what it’s there for.
Mike Blake: [00:17:12] Okay. Now, I want to switch gears a little bit. We’ve talked a lot about the real estate itself, but, of course, it takes more than a building to be an effective workspace. What about furniture? If I buy a Herman Miller chair, buy the snazzy microphone that I’m now working with at home for the podcast, can I deduct that as well? Does that work the same? Is it different? How does that work?
Matthew Steinberg: [00:17:42] So, it’s a little different. So, the answer is yes, you can deduct it. Say, you have an office and you decide to buy two chairs for clients to come sit, and each chair is $1,000. So, you spend $2,000 on chairs that are directly related to your home office. So, you would be able to accelerate those deductions because they’re called personal property. And they qualify under a different statute where you can accelerate the depreciation significantly faster. Then, you would be able to get immediate expensing or a deduction for something like furniture, chairs, computers, things like that. As long as it falls under, what we call, the de minimis threshold, which is set at 2,500 by the Internal Revenue Service.
Matthew Steinberg: [00:18:29] If you start purchasing pieces of property that are $5,000, $6,000, then you need to look into how we would depreciate things like that. But, currently, under the law, those would all qualify for something, we call, bonus depreciation, which right now is 100 percent. Meaning, you would get to expense it immediately under the bonus depreciation statute. So, I mean, you are in a good position in terms of if you need to purchase things like file cabinets, furniture, things like that, that are easily movable, those will qualify for that immediate depreciation or expensing.
Mike Blake: [00:19:07] Okay. I need to go back to the real estate part, because I almost forgot one question that’s really important. What about improvements to existing real estate? For example, I read an article in The Wall Street Journal, I’m going to say, about a month, maybe six weeks ago, where there is a host, I think, on Fox Sports, who basically converted one of his rooms into a home studio with different lighting, different paint, because apparently that works better on camera, soundproof and sound modification, all that kind of stuff. Can home improvements such as those potentially be a tax deduction opportunity as well?
Matthew Steinberg: [00:19:48] Yes. They can as long as it’s for conducting the business. So, if you go out and add a pool to your house, that’s not going to qualify for a business use of home. Unless you can prove that that pool somehow add to some sort of value or it’s related to your business. I mean, if you’re providing swimming lessons, sure. But for the example that you are providing, for the guy or the girl, instead of –
Mike Blake: [00:20:16] It’s a guy, it turned out.
Matthew Steinberg: [00:20:18] A guy. Okay. He had set up an in-home studio for his profession. Those improvements would qualify to be deducted as part of the business use of home deduction. And they are interior improvements more than likely. So, they would probably qualify for something we call a qualified improvement property, where you would get an accelerated benefit or deduction for it. So, that is something where you would be able to get a benefit. Now, if you’re just doing improvements all around the house and making repairs and painting rooms, that’s not going to necessarily qualify because it’s not related to the actual office space you’re using. Let’s say you paint the whole house, sure, you could allocate part of the cost to the office. But you couldn’t deduct your bedrooms and things like that where you’re just updating it and putting crown molding, and things like that. If you try to do something like that, you’re going to draw some attention from the Internal Revenue Service and increase your audit risk.
Mike Blake: [00:21:16] Now, can you write-off or potentially deduct services such as internet access, or even a portion of utilities, or maybe something else, you know, some other service you might buy for your home to work from home that you wouldn’t have if you didn’t need to do that?
Matthew Steinberg: [00:21:35] Yes. There’s something we call indirect and direct expenses. So, there are certain expenses that you’re going to have in your home, whether or not you have an office. You know, power bill, water bill, probably internet and cable, you’re going to have those things. So, we spoke briefly earlier about the square footage of a home and what is designated as the office space. So, we used 400 feet as the square feet of the office space and we used 2,000 for the total, so that was 20 percent. So, say, you have a $1,000 and we’ll call it $1,000 a month in power bills, and water bill, and cable bill. Twenty percent of that, we can designate or allocate to the home office. So, you get a $200 reduction, because 1,000 times 20 percent is $200.
Matthew Steinberg: [00:22:24] Now, there are other expenses that are more direct. Even though you’re using 20 percent of the house as an office, you have other expenses that are 100 percent. So, say, you buy or you pay for a website that’s only related to the office or to your business. Well, that’s going to be 100 percent deduction for the business. So, it’s not going to be like you have to allocate it to your house or things like that. Say, you have postage and things that you’re paying out of pocket that are only related to the business that are coming out of your businesses use of home, things like that are going to be 100 percent direct expenses, even though you only have 20 percent of the house as the office. So, you always need to be deciphering what’s a direct expense, which you get 100 percent benefit for, versus what’s an indirect expense, which you’re only getting a 20 percent benefit for because it’s allocated along the whole house.
Mike Blake: [00:23:18] Okay. Now, what about equipment such as computers, webcams, microphones, printers, things of that nature? Can that also potentially be written off?
Matthew Steinberg: [00:23:32] Yeah. So, those would all qualify as direct expenses for the business or the business use of home. So, you know, say, you need to get a webcam, say, it’s $500, that could be immediate write-off. Computer, printers, all those items would all qualify in the business use of home to reduce your business income and get you a lower taxable income and pay less taxes. So, those are all great ideas and, you know, they would all add to your benefit of having a home office and they’re all great to have.
Mike Blake: [00:24:12] Now, I’ve heard in the past that computers can be tricky and the IRS, at least, at one point, used to pay those extensive scrutiny because a lot of people kind of mix a computers personal use and – sorry – business use. So, if you have games on your computer, unless you’re a game developer, I guess, or game tester, that might be problematic. Was that the case or is that still the case now?
Matthew Steinberg: [00:24:47] You know, it’s a good point. You could say the same thing about cell phone usage. We have cell phones and, you know, do we deduct 100 percent of the cell phone bill? Or do you take 75 percent is business, 25 percent is personal? It’s a fine line. With the computers, the IRS really hasn’t released in recent years, you know, come down hard on taxpayers for buying a laptop and then deducting it all for business purposes, even though you may be using it slightly for personal, for de minimis reasons. You could technically say, if you want to be super conservative, you could allocate your usage of it and only deduct certain amount of it. But for the most part and for most of my clients, they’re going to be deducting those laptops primarily for business, more like maybe allocating those items.
Mike Blake: [00:25:52] Okay. So, I think there’s something on a tax return called a standard home office deduction. Am I right about that? And if so, how does that work?
Matthew Steinberg: [00:26:03] So, I think you’re referring to, maybe, the simplified method potentially. So, most most taxpayers, if they’re self-employed, will file something called a Schedule C, profit or loss report, to show their income and expenses, determine what their amount is that’s subject to taxes and self-employment taxes. And on that form, at the bottom, there’s a schedule called Form 8829 which is where you calculate your business use of home deduction. And that’s where you would calculate all the expenses related to your home, the direct and indirect expenses. And then, you would also be able to calculate the depreciation on the business use percentage of the home.
Matthew Steinberg: [00:26:47] Now, the IRS came out, several years ago, and put something out called a simplified method computation. And the reason they did this is, there were so many people taking a business use of home that it was just too much for the IRS to monitor. So, so many people were doing it. So, they said we’re going to give you something called a safe harbor limitation. And what it means by safe harbor is, if you take this deduction, you are free and clear. The IRS will not look at you and audit you. You can take this amount as a ceiling amount. You can deduct it and you are free and clear. You have no audit risk. It’s called a safe harbor deduction under the simplified method. And the way it works is, for every square foot that you had attributed to home office, you would get a $5 deduction. And it was maxed out at 300 square feet. And it hasn’t changed in the last year. So, the most you could get for a deduction was $300 times five square feet, which is 1,500 bucks.
Matthew Steinberg: [00:27:48] So, the IRS just gave you that as being a self-employed person. You don’t have to give them any information. You don’t have to put any data down. They’ll just give you a $1,500 deduction annually. They’re not going to ask you any questions. You just get it. So, that was put in place maybe five, six years ago. And the amount hasn’t been adjusted for inflation or anything like that. It’s kind of stayed at 1,500. And that has been what a lot of taxpayers have used, because sometimes that $1,500 simplified deduction is actually higher than what they would get if they computed an actual deduction. And you can choose and pick which one you want to do every year. You don’t have to stick with one and keep it going annually. If the actual costs and deductions of the home office are better, you can go to that. But there’s a risk there, because the IRS isn’t giving you that safe harbor. So, it’s always nice to do a comparison analysis. And that’s always why you want to get a good CPA to take a look at that for you.
Mike Blake: [00:28:47] Of course.
Matthew Steinberg: [00:28:47] I’m trying to sell a little bit here.
Mike Blake: [00:28:52] Yes. I did not know that it worked that way. Now, what if your space and equipment have dual purposes, right? As we record this, my office also doubles as my game room. Does that impact deductability? And is that as simple as just saying this room, say, 50 percent is for office and 50 percent is not? Or does it get more complicated than that?
Matthew Steinberg: [00:29:18] Well, you know, if you go and look at the regs, the IRS regulations and the black and white, it says in there that the space that you’re using is supposed to be dedicated and focused to the business. If you have a mixed use space or purpose for the space, then it’s not really designated for the use of the business. So, can you break it out and, say, maybe part of that space, maybe, there’s 500 square feet basement, and 250 is business and 250 is personal or just not related to the business. And the reason they do that is they don’t want you to create an office space that’s 2,000 square feet and really inflate your deduction by getting a lot more depreciation and really pumping up what your expense would be in order to reduce your taxable income.
Matthew Steinberg: [00:30:12] So, it’s pretty clear in the regs about the space and what should be used and what shouldn’t be used as a deduction in determining the square footage and what you can depreciate. That’s really, I guess, where it comes down to. And, also, if you have those indirect expenses, they don’t want you to be allocating more of the utility expenses and things that are more personal in nature to the business if they aren’t really qualifying. So, you have to kind of be careful about those things. You don’t want to overdo it. That’s what I would recommend to my client if they were asking these questions. You know, you don’t want to get too aggressive because then you start causing other issues.
Mike Blake: [00:30:51] Right. As they say down here, “Pigs get fat and hogs get slaughtered,” right?
Matthew Steinberg: [00:30:57] Yeah. That’s the saying I’ve heard quite a bunch.
Mike Blake: [00:31:06] You know, if you wanted to keep documentation, you know, we both know people that they just want to document everything. They just want to assume they’re going to be audited and be ready. You know, if you’re advising a client that were just dead set. And it sounds like you don’t really need to do this. But, of course, documentation is never a bad idea. If somebody listening just wanted to, if nothing else, to satisfy their own anxiety or to do things to document their home office or proactively substantiate, if you will, what kinds of things do you suggest they do?
Matthew Steinberg: [00:31:42] Well, I mean, you would want to maintain a file and you’d want to keep a separate books and records for the expenses that are related to the home office. You’d like to have spreadsheets set up where you can, at least, show on an annual basis that you’re breaking out the expenses or allocating them to the personal side of the home and on the business side of the home. You may even want to take a picture of your office space and just put it into the file that you have, whether it’s an electronic file or you’re still maintaining paper folders, because I still know people that do both.
Matthew Steinberg: [00:32:14] So, you know, if you want to really substantiate your case that you have a legitimate home office, those are the things you want to do. You’d want to keep a copy of your settlement statement from the house because that’s showing the value of the home. Because that’s what you’re going to be depreciating, a percentage of that, so you want to have all these kind of things in your file. The settlement statement, a spreadsheet allocating expenses properly, copies of the real estate document, copy of the real estate tax annually, copies of your mortgage interest statement, because all of these things are being allocated. I mean, if you want to maintain copies of your monthly bills from power companies, cable bills, water bills, anything related that could substantially be related to your business use of home office deduction, all those things you’d want in your file, if you’re just dead set on maintaining a perfect file.
Mike Blake: [00:33:07] We are speaking with Matthew Steinberg of Brady Ware & Company, and the subject today is, Can I or should I deduct my home office expenses from my tax return? Matthew, a couple more questions before we let you go and go back to helping clients. One question I have is, if you have a home and you’ve used it as a home office and then you sell it, are there any specific tax implications on the capital gains or anything else you can think of that you need to be aware of as you prepare to sell that property?
Matthew Steinberg: [00:33:45] So, that’s a good question. You posed a simple question that’s actually complicated, but I’ll do my best to answer it. So, first off, let me state that there is a rule out there that allows for your principal residency if you lived in it for two of the last five years, where you can get, what we call, exclusion of the gain up to 250,000 if you’re single and 500,000 if you’re married, filing jointly. So, what that means is, if you lived in the home for the last two years and you sell it for a million dollars, and your basis was half a million – obviously, two years, you double the value of your home, that’s great – but $500,000 of that is tax free. So, you wouldn’t pay any tax on your stuff. Or report the transaction to the IRS, but you don’t pay any tax on it. And it’s excluded from income tax or capital gains tax.
Matthew Steinberg: [00:34:39] So, getting back to your question, if you depreciate part of the property as a business use of home, is any of that recaptured as income tax? And the way that works is, say, you have depreciated $20,000 – what is called $20,000 – you are entitled to what we call an ordinary income tax deduction at that point, because it reduced your ordinary income by $20,000. So, ordinary income tax rates are higher than capital gains tax rate. So, now, we’re getting into a whole bunch of tax mumbo jumbo here, so I hope I don’t want to lose anybody.
Matthew Steinberg: [00:35:20] But at $20,000, you were able to get a deduction for ordinary rates. So, when you go to sell the home, that gets taxed at capital gain rates. So, the exclusion only allows you an exclusion for capital gains, not the ordinary component. So, when you sell the home, you would have to recapture, potentially, part of the business use depreciation when you sell the property, which would be taxed ordinary rate. So, 500,000 minus 20 would be 480, which was the original gain, 480 would be tax free. And then, you’d be subject to tax on $20,000 ordinary. So, there is a potential tax exposure if you do take actual expenses for a business use at home annually and depreciate it. So, you do need to be aware of that as a tax payer and as a self-employed individual who’s using a business use of home, that there could potentially be a consequence, a tax consequence or a tax liability, from selling a primary home that was used for business purposes at least a percentage of it. So, that is out there. If you have those issues, I would recommend a CPA to help you with that. It is complicated.
Mike Blake: [00:36:27] Yeah. We’ve probably only scratched the surface, too.
Matthew Steinberg: [00:36:31] Yeah. Yeah. That’s as basic as I can make it. That sounded complicated when I was listening to myself.
Mike Blake: [00:36:39] So, I’ve heard in the past – I don’t know if this is true or not, so I’d like you to either substantiate or debunk a myth – does putting in a home office deduction substantially increase the probability of an audit? Is that a flag the IRS kind of picks out and picks on?
Matthew Steinberg: [00:36:59] Well, let me first start with the percentage of individuals being audited has been decreasing every year for the last 20 or 30 years. The IRS is understaffed and they just can’t keep up with the volume of returns. So, let me put that out there, audit risk is already pretty low to begin with. I’m not telling you to go out there and do everything possible to make your return super aggressive and get all the benefits. I would never recommend anything like that. We want you to file a tax return correctly. We don’t want you to pay more tax than you need to pay. You pay the minimum tax which you’re required to pay.
Mike Blake: [00:37:37] Yeah. Of course.
Matthew Steinberg: [00:37:38] Every time you take a position on a return or you’re doing things that aren’t standard, you’re increasing your risk for audit. Now, I mean, I will go back and say that the IRS did implement what we call the safe harbor, which we talked about for a few minutes earlier, where you get that automatic 1,500 deduction based on 300 square foot, which is the cap. And if you do that, they’re not going to audit you. They’re going to stay away from you. But if you have a significant percentage of your home being used for a business deduction, you’re increasing your risk.
Matthew Steinberg: [00:38:14] If you have a 5,000 square foot house and you’re saying 2,500 of it is a home office, then you’re just putting yourself out there and drawing all kinds of red flags. Will you get audited? Maybe. I’ve got clients who’ve done everything right. They say for the last 40 years, and they’re just more audit prone and they get no changes. They don’t have any note. IRS comes in, spends years looking at their returns, and nothing happens. Other clients are a little more on the aggressive side in doing it that way forever. And they’ve never been looked at once. So, how lucky do you feel? I don’t want to say that. But, you know, it’s just some clients are unluckier than others and they do everything perfect. And other ones are taking some positions that may be are more aggressive, not necessarily wrong, but they’re just taking more aggressive positions and certain things and they never get looked at. So, does it increase your audit risk? The simple answer, yes. Will you be looked at? Who knows? I mean, it’s a mystery.
Mike Blake: [00:39:16] Yeah. I mean, there is a significantly random element. You know, in my opinion as a non-CPA, you know, the best defense against audit risk is just doing the right thing. Your number may just come up. I mean, there are some things, I think, that do flag audits. You know, estate, and gift tax issues, donations, those things seem to flag audits more. You know, the IRS will look for, in my experience, just what appear to be outsized deductions. And I think that’s automated, basically. But there is just sort of a random element, right? And your number just comes up and, you know, the best defense against an IRS audit is just don’t give them anything to audit.
Matthew Steinberg: [00:40:03] That’s right. You make a good point. The IRS has – you know, most of the returns are now electronically filed and they run it through a computer system, and they have the formulas in there and algorithms. Say, if you have $200,000 as income and you donate $200,000, that’s going to flag something. Like, how are you giving away all your money? Little things like that doesn’t necessarily trigger an audit, but it triggers potentially a notice or at least someone to review it. So, there are all those things in play. And the IRS system is getting more sophisticated on an annual basis as they computerized more and more of this and more returns get electronically filed.
Matthew Steinberg: [00:40:38] So, you make a good point that there are certain things that trigger notice and red flags and things to that extent. But, you know, there’s also the human element and, you know, is your number going to be up? And, obviously, the best offense is not the best defense, right? Is what they say? Or best defense is not the best offense? One of those.
Mike Blake: [00:40:59] One of those two. Well, Matthew, it’s been a good informative conversation. I’ve learned some things. I know our listeners will be learning some things, too, that they’ll either take back to their own CPA or maybe they’ll even take it back to you, which should be a good decision – speaking of decisions. But if people have more questions about this, how can they best contact you for more information?
Matthew Steinberg: [00:41:23] Sure. So, my name is Matthew Steinberg. My email address, msteinberg, S-T-E-I-N-B-E-R-G, @bradyware.com. You can also reach me at my cell phone – yeah, I’m giving my cell phone number – 678-468-1083. Since we’re not in the office as much anymore, it’s harder to reach me on the office line, so that is my cell phone number. So, please feel comfortable to reach out to me either via email or via my cell phone if you have additional questions. I would love to help you and be an adviser to you, if possible.
Mike Blake: [00:41:59] Well, Matthew, thank you. This is good stuff. And I have a feeling this could be one of those podcasts that people will be pausing and rewinding and taking notes. That’s going to wrap it up for today’s program. I’d like to thank Matthew Steinberg so much for joining us and sharing his expertise with us.
Mike Blake: [00:42:15] We’ll be exploring a new topic each week, so please tune in so that when you’re faced with your next executive decision, you have clear vision when making it. If you enjoy these podcasts, please consider leaving a review with your favorite podcast aggregator. It helps people find us that we can help them. Once again, this is Mike Blake. Our sponsor is Brady Ware & Company. And this has been the Decision Vision podcast.