The Home Office Tax Deduction for Your Small Business
There is a misconception among many people that taking advantage of the home office deduction immediately throws up red flags with the Internal Revenue Service.
While this may have been the case at some point in the past, in my decade-plus career as a practicing CPA I have definitely not experienced this to be the case.
And it is not a common belief among other practicing tax advisors.
So, if you’re eligible for the deduction you should absolutely take it!
Of course, that naturally leads to the question “Are you eligible for the deduction?”.
Fortunately, small businesses, which are often home-based, are often eligible for the deduction.
Read on to find out if you are eligible for the deduction and, if so, the options available to you for calculating it.
Note: The home office deduction is generally only available to sole-proprietorships who report their business income and expenses on a Schedule C. There are ways to get a deduction for using your home as an office space if your business is a Partnership or S-Corporation, but this post is written for the standard home office deduction available to sole-proprietors.
Home Office Deduction Eligibility
The home office deduction eligibility rules are a bit stringent.
Not everyone who thinks they qualify for a home office deduction technically does.
But, as I said in the introduction, home-based small businesses are often eligible.
In order to take the deduction, the IRS says you need an area in your home that is used regularly and exclusively:
- As your principal place of business,
- as a place where you meet with customers/clients or
- for business if it is a detached structure from your personal residence
First, you need a space that is used regularly and exclusively.
For most small businesses, this means you have a dedicated office area or workspace.
Ideally, it’s an entire room in your house, but it doesn’t have to be.
If you have a desk in a room of your house that you use regularly and exclusively, even if you don’t use the whole room for your business, you meet this condition.
The first of the next three conditions is the one that many people don’t meet.
For most small businesses, the home office has to be the principal place of business.
If you spend more time at any other location running your business than you do at your home office running your business, you do not meet this condition and you don’t technically qualify for the home office deduction.
That is, unless you regularly meet customers/clients in a dedicated area of your house or your home office is detached from the rest of your house.
Fortunately, many small business owners run their businesses primarily from home, which makes them eligible for the deduction.
If you run your small business from another office and spend a few hours a week working on it from home, you technically aren’t eligible for the home office deduction.
You get a deduction for all of the expenses associated with renting the other office space.
If you determine that you qualify for the home office deduction because you meet these eligibility requirements, there is one more hurdle you need to get over.
Your business needs to be profitable.
If your business does not have taxable income (i.e. your other business deductions exceed your business income), you can’t take a home office deduction.
So, you pass all the tests and determine you are eligible for a home office deduction?
Let’s look at how it is calculated.
How Much is the Deduction?
There are two different options when it comes to calculating the home office deduction: the regular method and the simplified method.
Under the regular method, you take a percentage of the expenses required for keeping up with your home.
The percentage represents the size of your home office area compared to the size of the rest of your house.
The most common method for calculating the percentage is to determine the square footage of the area you use for your office and divide it by the total useful square footage of your home.
Then, determine how much you spent on expenses for your home, including mortgage interest and property taxes for homeowners, rent for renters, insurance, utilities, repairs and home security service.
You can also take a depreciation deduction for this portion of your home, but if you take a depreciation deduction there are tax implications when you go to sell your home so you may want to discuss depreciating your home office with your personal tax advisor.
Let’s look at an example of how the regular method is calculated in practice.
In this example, you can see that the taxpayer would get to deduct 10% of their home expenses as a home office deduction.
Mortgage interest and property taxes are usually the biggest expenses for homeowners, which is important to understand because this has to be considered when you decide between whether you use the regular method or choose the simplified method for your home office deduction.
I discuss why in the simplified method section later in this post.
You may be wondering how to handle deductions that aren’t used entirely in your business but are used more than what you calculate your home office % to be.
Prime examples of this are internet or landline phone expenses, but the example below applies to any expenses that are both business and personal but for which the home office % does not make sense.
If you are paying $100 per month for internet and determine that you use the internet 75% for business and 25% for personal reasons, you can exclude this from your home office deduction and deduct 75% of your internet expense as an “other deduction” on your business tax return.
Additionally, if you incur expenses that are strictly for your home office (ie. repairs and maintenance on the home office area) you can deduct the entire amount.
The simplified method for determining your home office deduction amount is just that; simplified.
Determine how large your home office area is in square feet.
Multiply your home office square footage by $5 and you have your home office deduction!
This method is much easier, doesn’t require you to keep track of all of your home expenses and often results in a larger deduction.
It is relatively new, so not everyone knows about it.
The IRS introduced this method in 2013.
In the example in the Regular Method section above, the home office is 240 square feet, so the home office deduction would be 240 times $5, or $1,200.
Now, on the surface it may look like the regular method would yield a better result.
If you look at the example above, the home office % expenses total $1,885.
This is greater than the $1,200 calculated using the simplified method.
However, most homeowners itemize their deductions and are able to deduct their mortgage interest and real estate taxes on another section of their individual tax return.
In the example above, if you were to use the regular method for calculating your home office deduction, the $1,200 for mortgage interest and $300 for real estate taxes would be subtracted from the total amount you get to use as an itemized deduction.
If you use the simplified method, you still get to deduct this $1,200 and $300 as an itemized deduction and you get a $1,200 home office deduction, so it probably makes more sense to use the simplified method.
The point of this analysis?
Determining which method results in the most tax savings isn’t always simple and straightforward.
If you rent your home, it is likely that using the regular method will result in a bigger deduction but if you own your home you (or your personal tax advisor) may need to do a bit more analysis.
One last caveat regarding the simplified method: the maximum deduction under this method is $1,500.
So, if you’re home office space is greater than 300 square feet, you are capped at 300 square feet.
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Also, if you haven’t heard, there’s a new tax bill that goes into effect starting in 2018.