Home Office Deduction
The home office deduction can save qualifying taxpayers money. Self-employed people that work from home may be able to deduct expenses for the business use of their home.
Who can take the deduction?
The home office deduction is only available to self-employed taxpayers. People who are employed and working from home are not eligible for the deduction. The deduction is available to both owners and renters.
What business uses qualify?
To qualify for home office deductions, a part of the home must be dedicated exclusively to regular business use. Exclusive use means the space cannot also be used for personal purposes. To be eligible for deduction, the space must be 100% dedicated to business use.
The space must also be the principal place of business to be deductible, or it must be used as a place to meet clients, customers, or patients in the normal course of business.
Principal Place of Business
Principal place of business is determined by the relation to other fixed business locations, the importance of work performed at each location and time spent at each location. If a taxpayer has no other fixed business location, the principal location is wherever management and administrative work is performed.
Storage of Inventory and Product Samples
You are not required to meet the exclusive use test for area used for inventory and product sample storage.
Use of part of the home as a day care facility does not require exclusive use.
What expenses can I deduct?
Direct expenses, which are expenses specific to the business use of the home can be deducted. For example, if you paint your home office, the paint is deductible as a direct expense of the business use.
Indirect expenses are expenses for the entire property, a portion of which can be allocated to the business. For example, if the home office is 10% of the home, 10% of the electricity bill may be deductible.
Determining Business Portion of Home
Square footage is a common method for allocating indirect expenses (there are other potential methods, such as the number of rooms.) For example, if you have a 3,000 square foot home and 300 square feet is dedicated to business use, 10% of eligible indirect expenses would be allocated as business expenses.
The IRS offers the simplified method as an optional alternative to deducting actual expenses. Instead of deducting any actual expenses, you may deduct the actual square footage of the business use of home, up to 300 square feet, multiplied by $5.00 per square foot.
If you use the simplified method, there is no depreciation deduction or recapture upon sale of the home.
Under the simplified method you do not deduct mortgage interest or property taxes allocated to the business. Because these expenses have not been partially deducted, you may be entitled to a full deduction of them on other parts of the return (important for taxpayers that itemize.)
Caveat – The Depreciation Downside
Homeowners deducting actual home office expenses (not using the simplified method) must also deduct depreciation. Depreciation is a noncash expense representing the decline in a structure’s value over time. Depreciation yields a current deduction, but also triggers a future tax cost. Depreciation reduces your home’s basis, thereby increasing the taxable gain on the sale of your home. The portion of the gain on sale of your home attributable to depreciation cannot be excluded. It is subject to recapture and taxed at 25% regardless of other income.
Limitations on the business use of home deduction
The total amount of the home office deduction is limited to that business’s net income. Specifically, the maximum deductible home office expense is limited if it exceeds net business income.
If the home office expense deduction is limited by net business income, the expenses are split into tiers and deducted according to tier.
Tier 1 expenses are mortgage interest and property taxes that can be allocated to the business. Tier one expenses are fully deductible, even if they result in a net loss.
Tier 2 expenses get deducted next.
Tier 2 expenses are all expenses except tier 1 items (mortgage interest and property taxes) and depreciation.
Deductible tier 2 expenses cannot exceed the business’s net income reduced by tier 1 expenses. Tier two expenses that cannot be deducted due to the income limitation can be carried forward and may be deductible the following year, subject to the same limitation.
Tier 3 expenses cannot exceed net business income reduced by tier 1 and tier 2 expenses. Excess tier 3 expenses cannot be deducted or carried forward.
Home Office Expenses to Track
Good record keeping is essential to maximize the home office deduction. The IRS can be strict in their requirements. Potentially deductible expenses to track include:
• Mortgage interest
• Casualty losses
• Real estate taxes
• Repairs and maintenance
• Carryover amounts from previous years
• Other expenses connected to the business use of the home
The deduction for business use of your home can save you on taxes. The requirements are technical so be sure to work with a tax pro. The IRS requires you to be able to substantiate any deduction, so be sure to keep good records and documentation.
For assistance with self-employed and small business tax planning and preparation please call Aaron Hoffman at 203-548-0220.
This site contains general information for taxpayers. Each situation depends on its unique facts. Do not rely on this content as a sole source of information. Seek professional advice before taking any action based on this information.