Of all the deductions our tax code allows, the home office deduction should win the prize for “most likely to confuse and frighten.”
So let’s shed a bit of light and dispel some myths. As always, note this is intended to be general in nature and not all-inclusive of tax regulation.
Who can take the home office deduction?
You don’t have to be in business for yourself to take the deduction, but it is easier to qualify if you are. The IRS applies the “regular and exclusive use” rule for the area of your home used for business in order to qualify as a deductible home office. Exclusive use means you must use the area only for your business, and not for any other purposes at all. Having a bed in the room that guests use on occasion for instance will disqualify the deduction for the room, as will allowing your kids to come in and watch TV- but if you have an area of the room that is exclusively used, you may be able to deduct that particular space.
To qualify under regular use, the room must be your principal place of business, as a place to meet with customers or clients, on a regular basis for inventory storage (such as product samples), or as a daycare facility. For inventory storage and daycare, the exclusive test is not required. For regular use, you must use the space to conduct business, well, regularly (sometimes the IRS does say what they mean). Occasional use doesn’t cut it; it must be the primary place you carry out your business activities such as administrative or management tasks. You may have a place outside of your home to see clients as necessary, but if your business telephone line is in your home office, your files are in the home office, and you otherwise conduct your activities, scheduling, and management at home for instance, then you likely will qualify for a home office deduction.
For an employee to qualify, the conditions are stricter. The home office must be for the convenience of the employer, not simply because you prefer (even if your employer encourages it) to work from home and avoid the commute some days. Your employer must not have a regular office available to you, and requires you to work from home.
If you are employed by your own S-Corp, more complicated rules than can be addressed in this post apply.
Won’t taking the deduction make me a target?
Maybe. Certainly the IRS looks harder at returns containing the home office deduction, because of the potential for abuse. But if you can legitimately claim that deduction- and the others on your return- why not take advantage of something you are entitled to? The key is to be sure you are staying within the parameters of the law and keep excellent records. A tax professional can provide guidance, as well as help you address any correspondence from the IRS should you receive it.
What can I deduct?
The home office deduction allows you to write off a portion of the expenses of running your home. You can figure that portion in two ways: divide the area of the business portion of the home by the total living space, or if all of the rooms are roughly the same size and you use entire rooms, you can divide the number of rooms used for business by the total number of rooms in the house. That percentage is then applied to what are called “indirect” expenses of the office. Those are things like mortgage interest, qualified mortgage insurance, property taxes, homeowners’ insurance, association dues, utilities, security system, and rent. You may also deduct a portion of repairs that keep your home in good working order. A note about utilities: despite popular opinion, the cost of the first phone line into a home is never deductible. Long distance charges for business purposes on that line are deductible, as is second dedicated business line. Direct expenses on the other hand, are deductible in full. So the costs of painting your home office or installing shelves, for example, are 100% deductible.
In addition to those expenses, you are also allowed a depreciation deduction for the portion of your home used for business. To figure depreciation, you need to know the lesser of the cost or fair market value of your home (ignoring the land value) at the time you started using the home office. That amount then is deducted over 39 years. Permanent improvements to your home are also depreciated, rather than deducted in the year they are completed.
A new way to compute
The IRS recently released an alternative to doing those calculations when figuring the amount you can deduct for a home office. The new, simplified method allows for a $5 deduction per square foot for offices up to 300 square feet, or a $1500 limit. By choosing this method you won’t have to worry if you made the calculations correctly, or prove the amount of your utility bills. You may get a bigger deduction by sticking with the old way though. However, with the simplified method you also are allowed to deduct 100% of you property taxes and mortgage interest on Schedule A instead of splitting between personal and business use, which may boost the value of the deduction some. You also need to take into consideration whether or not your state accepts the new method. I guess the simplified method didn’t simplify everything.
What about when I sell my house?
Some are dissuaded from claiming the home office deduction because of the effect on a home sale. Normally, if your home has been your primary residence for two of the last five years, you may exclude up to $250,000 of gain (or $500,000 if filing jointly). When part of your home was used as a home office, however, you cannot exclude the part of the gain equal to depreciation allowed or allowable after May 6, 1997. Huh? What the IRS is getting at is that first, you must reduce the basis, or cost, of your home by the amount of the depreciation allowed or allowable. That may increase the gain on the sale, and cause you to exceed the exclusion amount. Secondly, the amount of the gain attributed to depreciation cannot be excluded, and must be recaptured- and taxed at up to 25%. So if you claimed $10,000 of depreciation over the years, you may be required to pay $2,500 in taxes. While that 25% is more than the current maximum capital gains tax of 15%, self-employed taxpayers receive a reduction in ordinary income tax and self-employment tax for the deduction, which may exceed 25%. Professional tax advice here is strongly recommended.
What is the benefit?
If you qualify for the home office deduction, the amount of benefit should be weighed with factors such as time spent recordkeeping, the additional cost of professional tax help, and the chances of an audit. For sole proprietors, as mentioned above, the benefits are a reduction in both ordinary income tax and self-employment tax. For employees, the benefit is not as clear cut. Employee home office deductions fall under miscellaneous itemized deductions, and are subject to a 2% floor, so the deduction is limited right off the bat. For taxpayers subject to our friend the Alternative Minimum Tax, the deduction is of no value. This is one of those times where it pays to be self-employed and work at home.
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