Small Business Taxes: The Home Office Deduction Explained
Tax time is right around the corner again, and that means it’s time to start checking those necessary tax-related tasks off your to-do list. From running your financial reports to speaking with a tax professional, it’s no wonder that so many business owners get overwhelmed this time of year. However, while it may be tempting to rush through your taxes just to get them over with it, it’s essential to go over each step of the process carefully. One area where you may spend a lot of time is with your deductions.
Deductions are important to your tax return because it lowers your taxable income, thus reducing your tax liability. In simpler terms, the more deductions you have, the more money you’ll be able to keep in your pocket.
But deductions can be tricky. The IRS has very specific rules on what you can deduct as well as how you calculate each deduction. One deduction that causes a lot of confusion among business owners is the home office deduction. Don’t skip out on adding this to your return, though, as it can make a significant dent in your tax debt. But before you claim this deduction on your return, it’s important to understand what the deduction is, whether or not you qualify, and how to calculate it. Taking the time to be accurate not only ensures you get the most out of your deductions but also accuracy is critical if the IRS audits you.
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What Is the Home Office Deduction?
The home office deduction is what it sounds like: a deduction on your federal tax return for the use of a home office. This deduction can be taken by freelancers, entrepreneurs, and small business owners that work from home.
There are, however, a set of rules and criteria put in place by the IRS. If you meet the requirements, you can lower your tax liability. If you don’t meet the criteria, you’ll be unable to claim this deduction. Claiming the home office deduction if you don’t qualify or inaccurately calculating the deduction can throw up a red flag to the IRS, leaving you vulnerable to a tax audit.
Who Qualifies For The Home Office Deduction?
Just because you work from home doesn’t mean that you automatically qualify for this deduction. While that certainly is part of the equation, there are other rules that you must meet to qualify.
What Qualifies As A Home Office?
You’re a renter and not a homeowner. You live in a condo. You work from home, but your home office is in a detached building. Before claiming the home office deduction, it’s crucial that you understand what exactly qualifies as a home office.
Renters and homeowners are eligible for this deduction, provided they meet all other requirements set by the IRS. A home office can be located in any property that provides living accommodations. Eligible properties include single-family homes, duplexes, apartments, condos, mobile homes, or even houseboats. Detached structures located on your property can also qualify as home offices. These structures include greenhouses, guesthouses, barns, and garages.
In short, nearly any room or structure on your property that is used for business purposes counts as a home office. However, to qualify for the home office deduction on your taxes, you must meet other requirements set by the IRS: The home office must be used exclusively for business, it must be used regularly for business, and it must serve as a principal place of business.
Your home office must be used exclusively for business purposes to qualify for the deduction. If personal activities also take place in the space, you are disqualified for claiming this deduction. For example, a spare bedroom that gets used on occasion as a guest bedroom does not pass the exclusivity test. Therefore, you would be disqualified from claiming the home office deduction.
There are two exceptions to the exclusivity rule. The first is if part of your home is used for the storage of inventory or samples. Simply storing some of your business supplies doesn’t cut it, though. You have to meet the following requirements to deduct this space:
- Your business sells products retail or wholesale
- Inventory or samples are stored for use in your business
- You use the space regularly for storing products or samples
- Your home is the only fixed location of your business
- The space is separately identifiable
The other exception to the exclusivity rule is if you operate a home daycare. To claim the deduction, you must meet the following requirements:
- You must provide daycare services to children, senior citizens aged 65 or older, or other individuals that are physically or mentally unable to take care of themselves
- You must have a license, have applied for a license, or be exempt from having a license to provide these services
If you’ve met the exclusivity rule of the IRS, great — you’re still on track to claiming the home office deduction. Now, it’s time to move on to the next requirement. To claim the home office deduction, the area that you are claiming must be regularly used for business.
If you use the home office only occasionally or incidentally, you do not qualify for the deduction. For example, let’s say that you have an office in a commercial building. Most of your business activities take place in your commercial space. Sometimes, though, you meet with clients or conduct conference calls after hours in your home office. This does not count as regular use, and therefore, you would be unable to claim the home office deduction.
Principal Place Of Business
To claim the home office deduction, your home office must be your principal place of business. If you have more than one place where you conduct business, you may still be eligible for the deduction, assuming that your home office is primarily where business activities take place.
If your business operates in more than one location, consider the amount of time spent at each site and the importance of the activities that take place there. Your home office must be where you regularly and exclusively engage in managerial and administrative activities related to your trade or business to receive the home office deduction. These activities include ordering supplies, billing, bookkeeping, and running reports. You must not have another fixed location where these activities frequently take place. If so, you will not qualify for the deduction.
If your office is a separate structure not attached to your home (e.g., a barn or greenhouse), you may still qualify for the deduction. This space must be used exclusively and regularly for business. It does not, however, have to be your principal place of business or where you meet clients or customers.
For example, a florist that owns a retail shop can claim a deduction on the greenhouse where flowers and plants are grown. While this separate structure may not be the principal place of business or where customers go, expenses can be claimed if the greenhouse is used exclusively and regularly for business.
Home Office Used As A Meeting Place
If you have multiple places of business, you may still qualify for the deduction if you meet with clients, customers, or patients regularly at your home. To qualify, you must meet these requirements:
- Physically meet with patients, clients, or customers
- Use that portion of your home exclusively and regularly for business
- This space must be integral to the operations of your business
Putting It All Together
To summarize, you can claim the home office deduction if you answer “yes” to all of the following questions:
- Is part of your home used for your trade or business?
- Is your home office used regularly and exclusively for your trade or business?
- Does your home office serve as your principal place of business?
Remember, if you use a portion of your home for storage or as a daycare, different rules apply. Different rules also apply if you use a separate structure for your business or if you meet with clients, customers, or patients in your home. For most businesses, though, passing each of these tests means that you’re another step closer to reducing your tax liability. If you’re unsure of whether you qualify, consider speaking with your accountant or a tax professional for guidance.
How To Calculate The Home Office Deduction
You’ve determined that you qualify for the home office deduction, so it’s time to do some calculations. There are two methods for calculating the home office deduction: the simplified method and the actual expense method. Let’s take a look at how each method works and how to determine which is the best option for your business.
The Simplified Method
The simplified method, as you can probably infer from its name, is an easier way of calculating your home office deduction. Using this method, you can deduct up to $5 per square foot of your office space, with a maximum cap of 300 square feet (or $1,500). To calculate your deduction, take the total square footage of your office and multiply it by $5.
Let’s say that you use your spare bedroom as your home office. Your spare bedroom measures 10-feet by 10-feet or 100 square feet. Multiply the total square footage by $5, and your deduction is $500. As you can see, this method is quick and easy but may not yield the highest deduction. If you have kept accurate records throughout the year and have proof of your expenses, you might want to try using the actual expense method, which we’ll discuss shortly. One last thing to note is that even though the simplified method doesn’t allow you to write off portions of your household expenses, some of your home-related expenses (such as mortgage interest and real estate taxes) can be itemized on Schedule A.
If using the simplified method, your home office deduction is reported on your Schedule C.
The Actual Expense Method
The actual expense method allows you to use specific expenses associated with using your home for business. While you may be able to get a larger deduction, this method is far more time-consuming and does require more extensive and accurate recordkeeping.
To start with this method, you need to determine your expenses — both direct and indirect. Direct expenses are all expenses that apply solely to your home office. For example, painting your office is an example of a direct expense. Direct expenses are fully deductible on your tax return.
Indirect expenses are a little trickier. These expenses apply to your entire home. Some examples of indirect expenses include:
- Property taxes
- Mortgage interest
- Security systems
- Certain casualty losses
Because these expenses are for your entire home, you are unable to use the full cost as part of your home office deduction. Instead, you must figure out the percentage of your home that’s used for business. Let’s look at a quick example.
Your home is 2,000 square feet. The spare bedroom you use for your office space is 200 square feet. Divide the square footage of your office (200) by the total square footage of your home (2,000). In this example, your home office comprises 10% of your home.
Now, how would this apply to your expenses? Let’s say that the amount of rent you paid for the year was $12,000. Use the percentage we calculated above (10%) to determine how much of this expense is deductible for business purposes. In this example, 10% of $12,000 is $1,200.
When using the actual expense method, your expenses are reported on IRS Form 8829. Make sure to read each section carefully and follow the instructions closely to make sure your deductions are correct. And, of course, it should go without saying that you should use your bank statements, bills, receipts, and other documents to ensure your numbers are accurate.
Which Method Is Right For Your Business?
Now that you know about the two methods used to calculate the home office deduction, it’s time to determine which is right for your business. Every business is different, so what works for one business may not work for you. Luckily, there are a few things to keep in mind to help you decide which is the best option for your specific situation.
Generally, you’ll want to select the method that saves your business the most money. However, there are a few other factors to consider. If you haven’t kept accurate records of your expenses, for example, you’ll want to use the simplified method. If you didn’t have a lot of expenses and gathering your receipts and other documents would be too time-consuming for very little payoff, the simplified method might be your best bet.
However, if you know that you have many expenses related to your home office, you’ll find that going the actual expense route will be worth the extra effort.
If you need some extra guidance, consult with your accountant or tax professional. You can also take advantage of the many resources available through the IRS, including a side-by-side comparison of both methods.
How Tax Changes Affected The Home Office Deduction
The Tax Cuts & Jobs Act of 2017 resulted in tax reform for the first time in decades. One significant change that came about as a result of this tax overhaul affects the home office deduction. Previously, employees could deduct unreimbursed expenses that exceeded 2% of their adjusted gross income. These included home office expenses for employees that worked remotely, even if just on a part-time basis. Unfortunately, the TCJA eliminated this deduction.
In other words, if you’re an employee that works for someone else from your home office, you are not allowed to claim a home office deduction on your tax return. Only self-employed individuals can claim this deduction, provided they meet all of the requirements discussed earlier.
Final Tips For Taking The Home Office Deduction
While it may be difficult to understand, it’s important to not skip out on taking a home office deduction if you qualify. Before you get started on your taxes, keep the following points in mind:
- Keep all receipts and other documentation in case the IRS audits you. Having your documentation in order is also necessary for accurately calculating your deductions.
- Understand the requirements for the home office deduction, and take the time to evaluate the methods for calculating this deduction to ensure you save the most money.
- Take advantage of the resources provided by the IRS to get a better grasp of the home office deduction. One great resource is Publication 587 (Business Use of Your Home).
- Always consult with your accountant or a tax professional to ensure you’re getting the best advice for your specific tax situation.
Don’t qualify for the home office deduction? Don’t worry — there are plenty of other small business deductions to help you save money. And be sure to check out our Small Business Tax Prep Checklist, so you’re fully prepared this tax season. Good luck and happy filing!