Review of tax changes for 2013…first installment

For all the rhetoric coming out of Washington, 2013 was actually a fairly calm year in terms of tax changes…at least in terms of tax changes that will affect many people. Although as we’ll see next week, a small percentage of filers actually experienced an enormous change. (Hint: it involves a Supreme Court decision…)

So without any big, sweeping changes to talk about, I’ll touch on a handful of changes over the next few weeks that will either affect a fairly significant portion of taxpayers, or have a very large impact on a small portion of taxpayers. This week I’ll start with an item that affects a fair number of taxpayer…the home office deduction.

The home office deduction is one of the more complicated pieces of the tax code that people commonly encounter. But in 2013 the IRS announced it will offer a very simplified option for taking the home office deduction. As I’ll explain, this option will be beneficial for most home-owners, especially in low cost areas. On the other hand, most renters, especially renters in expensive areas, will want to pass on this option. (Fortunately, the simplified option is just that, an option. You can still calculate your home office deduction under the old rules if you prefer.)

First, a quick background. The home office deduction is available to anybody who uses a portion of their home regularly and exclusively for business purposes. This part hasn’t changed.

Under the old method, the amount of the deduction was calculated by finding the ratio of the square footage of the home office to the entire square footage of the home. This ratio was then multiplied by various expenses related to maintaining a home such as utilities, insurance, mortgage interest, rent, etc. In addition, there are various instructions related to which expenses are always deductible, which expenses are only deductible to the extent of business profits, and so forth.

Under the new method, any area that meets the definition of a home office is eligible for a deduction of $5 per square foot, up to a maximum of 300 square feet (or $1500). So, for example, if you use a 200 square foot room as a home office during the tax year, you can deduct $1000 as a home office expense.

Homeowners can still deduct the full amount they pay for mortgage interest and real estate taxes on Schedule A. Homeowners no longer deduct depreciation, which means no longer having to track depreciation over time and add that depreciation to income when the home is later sold. For these reasons, many homeowners will likely benefit from using this simplified method. In addition to fewer record-keeping hassles, many homeowners will actually get a larger deduction overall when considering that mortgage interest and real estate taxes will still be fully deductible. This won’t be true in every case, particularly if you pay a lot for utilities, home insurance, or other expenses that aren’t otherwise deductible. But as a general rule, if you own your home, you might want to consider using the simplified method.

For renters, on the other hand, you’ll probably want to continue tracking what you pay in rent and other costs so you can keep using the standard method. The reason for this is simple — you usually can’t deduct rent unless it’s a home office expense. So, let’s say you rent in even a low-cost area where you pay only 50 cents per square foot in monthly rent (this works out to $750 per month for a 1500 square foot home, just to give you an idea). Even at this rate, you’re paying $6 per square foot each year in rent alone. Plus you’re probably paying utilities on top of that, and maybe even insurance and some other costs as well. So being able to deduct $5 per square foot isn’t a particularly good deal for you. And if you’re in a high-rent area, like the SF Bay Area, you’re probably paying at least $1 per square foot each month, or $12 per year, so taking a deduction of only $5 per square foot doesn’t make much sense.

It’s a common trade-off in the tax world. Everybody claims to want simplification. But the downside to simplification is some people pay more and some pay less. And not many people like simplification if it means they pay more in tax. Fortunately in this case, every taxpayer has the choice. If taking the simplified option will mean a much smaller deduction for you, then keep doing things under the old method. But if you can save money, or even come out close to even, then your tax return will be getting a little simpler in 2013.

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