About the Home Office Deduction

Tax clients ask me all the time about taking a home office deduction. That topic has come up even more often since COVID-19 has so many people working at home. However, everyone with an office at home isn’t eligible for a home office deduction, even if she or he owns a business. Lots of rules apply. It can be pretty confusing. 

So, let’s “un-confuse” the topic:

  1. Who is eligible for a home office deduction?

Only individuals who own a business are eligible for the deduction. Yes, some employees used to be eligible under special circumstances, but those rules changed at the end of 2017. Now, only business owners who use space in her or his home exclusively and regularly to substantially conduct business operations can consider taking a home office deduction. No non-business activity can be conducted in a home office. That means no personal items in the home office, even clothes in the closet.

  1. What home expenses can be deducted?

Deductible home office expenses are either direct or indirect, based on the expense type and business percentage of the home used for business. The most common method used to calculate the business percentage is dividing the square footage used exclusively for business by total square footage. Shared spaces, like hallways, cannot be included in office space.  

  • Direct Expenses: Expenses that benefit only the home area that is exclusively used for business, such as painting or repairs in the home office, are direct expenses that are fully deductible.
  • Indirect Expenses: Expenses for keeping up and running the entire home, such as the mortgage interest, real estate taxes, insurance, utilities, and general repairs are deductible based on the business use percentage, described above.

Expenses to maintain the non-living home space, such as lawn care, are not deductible. For business owners who don’t want to hassle with tracking all the various home office expenses, the IRS has a Simplified Option that allows a standard deduction of $5 per square foot, limited to 300 square feet.  

Eligibility for a home office deduction is determined by a lot of rules that can be confusing. We address the basics here, but there’s more to it. Details and examples are on the IRS website at https://www.irs.gov/businesses/small-businesses-self-employed/home-office-deduction.

RMD Rule Reminder

Keeping up with tax rule changes was never easy. But the flurry of tax changes in response to the COVID-19 pandemic has been absolutely head-spinning. A few of those changes impact the rules for required minimum distributions (RMDs) from retirement accounts. RMD rules are how the IRS prevents taxpayers from avoiding tax payments on retirement funds that were invested pre-tax, or before any taxes were paid on the income used for the retirement investment.

On December 20, 2019, the Setting Every Community Up for Retirement Enhancement Act (aka “Secure Act”) was signed into law. The Secure Act changed IRA distributions and contributions in three big ways:

  • Required Minimum Distribution (RMD) Age Increase

Under prior tax law, RMDs had to begin no later than April 1 following the year in which a person turned age 70½. For taxpayers who were not already age 70½ by December 31, 2019, the age to start taking RMDs is extended to 72. Distributions don’t have to be postponed to 72; it’s just an option. What’s better – waiting or not – depends on individual circumstances.

  • Contribution Age Restrictions Repealed 

Before the Secure Act, workers over age 70½ were not eligible to make contributions to an IRA. That contribution age limit has been eliminated. Yea! Slight damper on that celebration, though – the same rules about who can and cannot deduct a traditional IRA contribution apply, regardless of age. 

  • Inherited IRA “Stretch Distributions” Eliminated for Non-Spouses

Traditional IRAs that are inherited by someone other than the owner’s spouse can no longer be distributed over the life of the beneficiary. Distributions now must be taken within a ten-year period after inheritance. This new rule eliminates the options for non-spouse beneficiaries to use inherited traditional IRAs as part of his or her own retirement planning.

So, what does this mean for 2021 RMDs?

  • Individuals who reached 70½ in 2019 or earlier and were not required to take an RMD for 2020 are required to take an RMD for 2021 by December 31, 2021. 
  • Individuals who did not reach age 70½ in 2019 will reach age 72 in 2021 will have their first RMD due by April 1, 2022, and their second RMD due by December 31, 2022. 
  • To avoid having both amounts included in their income for the same year, the taxpayer can make the first withdrawal by December 31, 2021, instead of waiting until April 1, 2022. After the first year, all RMDs must be made by December 31.

Tax rules are always changing. Keeping up is always challenging. For help to meet the challenge, checkout the IRS website – HTTPS://WWW.IRS.GOV/NEWSROOM/TAX-TIME-GUIDE-IRS-REMINDS-TAXPAYERS-OF-RECENT-CHANGES-TO-RETIREMENT-PLANS.

Tax and Retirement Savings with a SEP IRA

Every taxpayer wants to reduce her or his tax bill. Business owners, especially, are constantly on the hunt for tax deductions. In addition, business owners who want to retire some time in the future are looking for ways to fund that nest egg. My tax clients who own their own businesses ask about tax and retirement savings regularly. That’s at least one thing that COVID-19 hasn’t changed!

Good news for business owners who want tax and retirement savings – they can do both with a SEP IRA! A “Simplified Employee Pension Individual Retirement Arrangement,” or SEP IRA, is the retirement plan of choice for many small business owners. Here are three reasons why:

  • Easy and Flexible

A SEP IRA is easy to set-up with your bank, your investment advisor or a mutual fund. Just set it up and fund the account before filing the year’s tax return, or by the tax return due date, including extensions. Annual contributions amounts are flexible, which is good if business cash flow varies from year-to-year.

  • Generous Contribution Limits

A SEP IRA allows you an annual contribution of up to 25 percent of net business profits, after netting out the deductible half of self-employment taxes. That calculation is a little tricky so you’ll need some help to get it right. There is an annual dollar limit, too. For 2021, it’s up to $58,000. Contributions must be made for eligible employees.

  • No Costs

A SEP IRA has no start-up or operating costs that are often required for a conventional retirement plan. However, any investments selected to fund the account may have a management or investment advisory fee. It’s important to get a clear understanding of any fees or charges that will defray your retirement funds.

Business owners should keep in mind that distributions from a SEP IRA work just like a traditional IRA – any funds taken out before age 59½ are subject to a 10% early withdrawal penalty, on top of the federal and state income tax. 

Saving for today and tomorrow at the same time could be the best news of 2021! Business owners on the hunt for ways to achieve tax and retirement savings at the same time should set up and fund a SEP IRA. Want to know more? As usual, the IRS website has more helpful details, at https://www.irs.gov/retirement-plans/plan-sponsor/simplified-employee-pension-plan-sep.

Expanded Educator Deduction for COVID-19 Safety

The educator deduction for out-of-pocket classroom expenses started as a temporary tax law provision in 2002. Primary and secondary schoolteachers could deduct up to $250 of the unreimbursed cost of books, supplies, computer equipment, and supplementary materials used in the classroom. In 2015, the deduction was made permanent. In 2016, the deduction was expanded to cover professional development expenses and was indexed for inflation.

Even with indexing for inflation and before the pandemic, $250+ a year did not put much of a dent in teacher spending. COVID-19 safety needs have made classroom expenses spike, just like other work environments. In June 2020, AdoptAClassroom.org surveyed U.S. educators to ask about classroom expenses during distance learning. It was not shocking to learn that teachers spent an average of $745 for classroom supplies in the 2019-20 school year. Almost half of the responding teachers reported spending more because of distance learning. 

The COVID-related Tax Relief Act of 2020 expanded the educator deduction further to help teachers afford the challenges of distance learning and returning to the classroom. Here’s what you need to know about the expanded educator deduction:

  • Who is Eligible for the Deduction?

You’re an eligible educator if, for the tax year you’re a kindergarten through grade 12 teacher, instructor, counselor, principal, or aide for at least 900 hours during the school year. Services must be performed in a school that provides elementary or secondary education as determined under state law.

  • What Safety Items Qualify?

COVID-19 protective items include, but are not limited to face masks, disinfectant, hand soap and sanitizer, disposable gloves, physical barriers like clear plexiglass, air purifiers, and other items recommended the Centers for Disease Control and Prevention for the prevention of the spread of COVID-19.

  • When Can Safety Items be Included?

Qualified expenses include the amounts that you pay or incur after March 12, 2020, for personal protective equipment, disinfectant, and other supplies used for the prevention of the spread of coronavirus. The deduction is for expenses paid or incurred during 2020 are deductible on your 2020 federal tax return.

Still not sure if you or someone that you know is eligible for the expanded educator deduction for COVID-19 safety items? Read more details at https://www.irs.gov/taxtopics/tc458.

Taxes for Married Couples in Businesses

Married couples who also operate a business together live a complex life. Commingling personal and business, experiencing 100% togetherness, is tough enough. Throwing taxes into the mix could be the straw that breaks the proverbial camel’s back and busts that togetherness apart. But it doesn’t have to be that way.

By default, according to the IRS, two or more individuals in business together without incorporating operate as a partnership. Partnerships are a complicated way to operate from a tax perspective. Partnerships file a separate income tax return, and each partner receives a Form K-1 to report for her or his pro-rata share of income and expenses, used to prepare the partner’s individual income tax return. Partners must also track the basis of partnership interest and any loans to or from the partnership, which impacts how distributions are taxed.

Married couples can get an exception to all those partnership complexities, if each spouse is an owner and materially participates in operating a business that is not formed as a Limited Liability Company (LLC). Instead of a partnership, spouses can elect to treat the business as a joint venture. The joint venture election breaks down to four simple steps:

  • Make the Qualified Joint Venture Election by filing a joint individual tax return. Spouses must consider profits and losses based on spouse’s interest and level of material participation in the business. Once the election is made, if the spouses receive an IRS notice asking for a partnership tax return, they should call or write to the IRS advising them of the qualified joint venture election.
  • Divide Profit and Loss between Spouses by dividing all items of income, gain, loss, deduction, and credit between them in accordance with each spouse’s level of material participation in the joint venture. The percentage allocation should be consistent for all items and reflect the relative percentage of participation. Allocations should be documented and updated for any changes in participation.
  • File Two Separate Business Schedules on the spouses’ individual income tax return. Each business schedule (i.e., IRS Schedule C or Schedule F) should be prepared with each spouse’s allocated share of income and expenses. The net profit or loss for the business schedules for each spouse is combined and reported on Form 1040, Schedule 1, Line 3. Net combined profit or loss is included in overall total income.
  • Report Net Profit as Self-Employment Income so each spouse’s earning from self-employment are credited and the applicable self-employment taxes are paid. Spouses who elect qualified joint venture status are treated as sole proprietors for federal tax purposes. A separate Schedule SE to report self-employment tax must be filed for each spouse to accurately report the net self-employment income.

Need more details about simplifying tax complexities when you are running a business as a married couple? The IRS has it for you here – https://www.irs.gov/businesses/small-businesses-self-employed/election-for-married-couples-unincorporated-businesses.

Beware of Scams During Tax Season

Scam artists prey on their victims all year long, but scam activity seems to spike during tax season. It must be “prime time” to snare victims because they are more abundant – everyone is preparing and filing their returns to meet the April 15 deadline. Scammers can’t resist all those opportunities to fool or intimidate taxpayers who are in the middle of an unpleasant task that makes them nervous and vulnerable, especially online.

Since 2014, the IRS has announced its “Dirty Dozen” top tax scams. The top twelve for 2020 include five scams that are more likely to occur during tax season, targeting taxpayers with malicious intent to steal their refunds, bank account number, or personal information. Here are alerts to watch out for on the five tax-related scams highlighted by the IRS:

  • Phishing: Taxpayers should be alert to potential fake emails looking to steal personal information. Don’t click on links claiming to be from the IRS, or any other sender you’re not expecting or that you do not know. Be wary of emails with embedded links or invitations to see or learn more − they may be nothing more than scams to steal personal information.
  • Unscrupulous Return Preparers: Most tax professionals provide honest, high-quality service, but dishonest preparers pop up every filing season. They commit fraud, harming innocent taxpayers, or talk taxpayers into doing illegal things, like inflating deductions. These scammers may also have taxpayers deposit refunds into tax preparer accounts.
  • Offer in Compromise Mills: Misleading tax debt resolution companies can exaggerate the chance to settle tax debts for “pennies on the dollar” through an Offer in Compromise (OIC) for a hefty fee. Later, the taxpayer learns that she or he is not one of the small number of individuals who are qualified to even apply for an OIC, after the fee is paid and it’s too late.
  • Fake Charities: Criminals frequently exploit natural disasters and other times of crisis by setting up fake charities to steal from well-intentioned people trying to help in times of need. Unfortunately, this is nothing new. The current COVID-19 pandemic and recent winter storms in Texas are examples where scammers take advantage of your compassion.
  • EIP or Refund Theft: Refund fraud and theft remain a pervasive threat. In this past year, criminals also turned their attention to stealing Economic Impact Payments (EIP) as provided by the Coronavirus Aid, Relief, and Economic Security (CARES) Act. Scammers often defraud taxpayers by promising payments more quickly but divert the payments instead.

Don’t get caught up in one of these top tax scams while you are busy filing your 2020 income tax returns. To learn more about these scams and how to protect yourself, check out the IRS website at https://www.irs.gov/newsroom/irs-unveils-dirty-dozen-list-of-tax-scams-for-2020-americans-urged-to-be-vigilant-to-these-threats-during-the-pandemic-and-its-aftermath

Residential Energy Tax Credits Extended

If you didn’t get all your home improvements done in 2020, and you think you missed out on some valuable residential energy tax credits, you’re in luck. Some renewable energy tax credits were extended. Others are still available at a lower rate. Even better, some tax credits were retroactively extended back to 2018. That could mean money back on your 2018, 2019, 2020, and, in some cases, your 2021 income tax liability.

Energy tax credits are an incentive for homeowners and builders to make energy-efficient improvements or upgrades that use less energy and protect the environment. For example, ENERGY STAR certified products are independently certified to use up to 30% less energy. Less energy use means a lower energy bill. It could also mean your lowering your taxes.

Here are six tips about Residential Energy Tax Credits:

  • Renewable energy tax credits are 22% of the cost for solar energy systems, fuel cells, small wind turbines, and geothermal heat pumps that are placed in service during 2021. Tax credit limits depend on the credit amount and your tax situation.
  • Residential Energy Property Tax Credits have been retroactively extended for qualified improvements from December 31, 2017, through December 31, 2021. These credits are generally 10% of the cost, up to $500, or a specific amount from $50-$300, depending on the improvement.
  • Improvements that qualify for the Residential Energy Property Tax Credit include qualified heat pumps, central air, boilers, furnaces, water heaters, circulating fans, and biomass stoves.
  • Qualified energy efficiency improvements that also qualify for a residential energy credit include energy-efficient insulation, metal and asphalt roofing, windows, doors, and skylights. The credit does not include the installation cost.
  • Energy credits apply to your newly-constructed or existing home that is used as your primary residence or your secondary home. These credits do not apply to rental properties.
  • You can take advantage of retroactively-extended energy tax credits by amending your federal income tax return up to three years after the original filing deadline (e.g., April 15, 2021, for a 2017 income tax return originally due April 15, 2018).

Home improvements that save on your energy costs could also lower your tax liability. Not only could 2020 improvements qualify for a tax credit, some of the qualified home improvements you made in the last three years could lower your prior-year tax liability, too. Want to know more? Check out the ENERGY STAR website https://www.energystar.gov/about/federal_tax_credits.

Final Worker Classification Rules

Lawsuits about worker classification weren’t front-page news before Uber and Lyft started fighting traditional interpretations of the law by treating workers as independent contractors. What used to be boring hiring details are big headlines about big-name court cases fighting over whether workers are employees or independent contractors. And, as you can imagine, worker classification issues have gotten bigger as the gig economy has exploded.

Uber, Lyft, and other businesses that provide apps for gig workers fought and won legal battles to classify those workers as independent contractors, not employees. Using the independent contractor classification saves businesses money in employer payroll taxes and other employee-related expenses. Workers classified as independent contractors assume more responsibility and cost, like paying self-employment taxes and making quarterly tax payments.

Recent court rulings about worker classification have created some confusion among employers. The U.S. Department of Labor (DOL) stepped in to help businesses and workers comply with applicable tax law. DOL recently issued a final rule that takes effect on March 8, 2021, to clarify the standards for determining whether a worker should be considered an employee or an independent contractor.

Three aspects of the final DOL rules that businesses and workers should know:

  • An “economic reality” test is used to determine whether a worker is an independent contractor or is “economically dependent on an employer for work” (i.e., an employee). The rule defines two “core factors” to help businesses determine whether a worker is economically dependent on someone else’s business or is in business for her- or himself.
  • The first of the two core factors isn’t just one thing; it relates to a series of conditions. These include the degree of control of the employer over the work, the amount of skill required to perform the work, and the degree of permanence of the working relationship. For example, an independent contractor is free from the control and direction of the hirer, is sufficiently skilled to work autonomously, and is providing services that are temporary or intermittent.
  • The second core factor relates to whether the work being performed is integrated with or separate from the overall business. An independent contractor performs work that is outside the usual course of the hiring entity’s business, either a specialized skill or temporary need for additional resources.

Worker classification issues have gotten bigger, along with the expansion of the gig economy. Determining whether a worker is considered an independent contractor or an employee can be complicated, which is why DOL issued clarifying rules. Worker classification decisions assign responsibilities and costs to the employer or the worker, so it’s important to get it right.

Need more information? The IRS addresses worker classification at https://www.irs.gov/businesses/small-businesses-self-employed/independent-contractor-self-employed-or-employee.