If you are a small business owner, an independent contractor, or someone who maintains an office at home for the convenience of your employer, you may qualify for a tax break by using the home-office deduction.
The home-office deduction allows you to deduct a portion of the cost to run and maintain your home as a business expense. The amount of the deduction is the percentage of expenses that your office square footage represents of your home’s total square footage.
Done properly, this deduction can reduce your taxable income substantially, generating a tax savings. A word of caution: This deduction is frequently abused, but, on the other hand, often overlooked. Just because this deduction is a common source of tax fraud doesn’t mean you shouldn’t take it if you qualify for it.
Home Office Deduction
How the IRS Defines a Home Office
Whether you convert a bedroom, den, basement, attic, or garage into an office, the IRS does not specify what kind of facility can be an office. They do, however, have two rules about the use of the space. To qualify to deduct expenses for business, you must use that space:
- Exclusively and regularly as your principal place of business
- Exclusively and regularly as a place to meet clients, customers, or patients in the normal conduct of your business
If you are an employee who designates space at home as an office, there are two additional requirements:
- Your business use must be for the convenience of your employer.
- You cannot take the expense of the office space if it is rented to your employer.
What the IRS Means by Regularly and Exclusively
Regular use means that you use the space on a regular basis, not on an occasional or incidental basis. If you use your den once or twice a year for a client conference, that does not meet the standard of regular use and does not qualify as a home office.
Exclusive use means that you use the space only for business. If you meet clients regularly in your den, but your family also uses your den to watch TV, then the den does not meet the standard of exclusive use and does not qualify as a home office.
A part of a room can be designated as an office even if other parts of the room are used for other purposes. If, for example, you have a desk, chair, filing cabinet, and copier in a 50-square-foot area of a 120-square-foot room, that space can be a home office if it meets the regular and exclusive business use criteria.
Home Expenses That Count Toward the Deduction
IRS Publication 587 notes that allowable office-in-home expenses are of three kinds: Direct (applying to the office only, such as repainting the office), Indirect (applying to the entire home, such as utilities), and Unrelated (applying to neither the office nor the home itself, such as lawn care). The direct expenses can be deducted in whole; the indirect expenses are deducted proportionately, according to the office square footage (compared to the square footage of the total house); the unrelated expenses are not deductible.
Indirect expenses might include the following:
- Mortgage interest
- Qualified mortgage insurance premiums
- Property taxes
- Rent (if you do not own the home)
- Utilities and services (like trash removal and cleaning)
- Repairs (unless the repair involves only the office, then it is direct)
- Security system
- Casualty losses
Noticeably absent from this list is telephone. The basic charge, including taxes, of the first landline to your property is a personal expense and not deductible, although long-distance costs made for business purposes are deductible separately on Schedule C (not as part of the office-in-home expenses). The cost for a second line to the office for business purposes is a direct deduction. A cell phone plan may also be partly or wholly deducted separately, depending on the percentage of business usage.
How to Calculate
If you opt for the general method using Form 8829, Expenses for Business Use of Home, the first task is to calculate the percentage of business use. To do this, you divide the square footage of your office space by the total square footage of the home. As an example, assume your home has 1,200 square feet and your office is a room that is 10 x 12 feet (= 120 square feet). The percentage of office use is 120 square feet / 1,200 square feet x 100 = 10%.
If you do not know the square footage of your home, you can check with the county assessor’s office, which may be able to provide you with that information. The IRS allows you to use “any other reasonable method” to determine the percentage of business use, so if the rooms in your house are of approximately equal size, you can divide the number of rooms used as office space by the total number of rooms to find the percentage of business use. However, the square-foot method is more precise.
To continue the calculation, let’s say that you had the following indirect expenses:
- Mortgage: $1,200 per month x 12 months = $14,400
- Property taxes: $1,000 x 2 payments per year = $2,000
- Hazard insurance: $50 per month x 12 months = $600
- Electricity: $80 per month x 12 months = $960
- Gas: $40 per month x 12 months = $480
- Sewer, water, and trash: $60 per month x 12 months = $720
- Furnace repair: one time cost of $1,840
In this example, the total cost of running the home for the year is $21,000. Since we previously determined that the business portion of the house is 10% of the total, then the office-in-home expense is: $21,000 x .10 = $2,100.
If you had a direct expense of $200 to paint the office, you could add this amount to the indirect expense total of $2,100 to give a total expense deduction of $2,300.
If you are using Form 8829, after calculating your deduction for the business use of your home (Part II), you can figure your depreciation deduction in Part III. Depreciation is a mechanism for you to deduct an amount for the wear and tear from normal use of your property over the life of the property. For the purpose of this depreciation, the useful life of the property is 39 years. To figure your depreciation, you need the following:
- Your basis in the home on the date you began to use your office (usually your cost plus the cost of any improvements to the property): $300,000
- The cost of the land: $50,000
- The date you first started using your office: January 1, 2016
- The depreciation factor (from the Instructions for Form 8829): 2.461%
- The percentage of business use: 10% in our example
Since land does not depreciate, the calculation is done as follows:
($300,000 – $50,000) x .02461 = $250,000 x .02461 = $6,152.50
The business use depreciation is 10% of that $6,152.50: $6,152.50 x .10 = $615.25
This amount is carried back to Part II to complete the business use expense deduction:
$2,300 + $615.25 = $2,915
This total is carried to your Schedule C, line 30.
Not everyone wants to track their annual expenses and maintain proper records in the event of an audit. In 2013, the IRS allowed small business owners to elect a simplified method for calculating an expense for a home office. The election is taken on Schedule C (Part II, line 30), in which case Form 8829 is not needed.
The simplified method for 2016 allows a $5-per-square-foot deduction up to a maximum of 300 square feet. Therefore, for our 120-square-foot office in the above example, the simplified method would allow a deduction of 120 x $5 = $600, which is significantly less than the calculated method allowed. Moreover, with the simplified method, you are not allowed a depreciation deduction. However, the upside is that you do not have to recapture the depreciation later, when you sell the property.
Additional Deductions and Exceptions
If you use an area of your home for storage of inventory, for example, the general area does not have to be used exclusively. The area taken up by a shelving unit in the den on which you keep inventory or product samples can be included in the deduction, even though the entire den is not used exclusively for business. In addition, if you have a day care in your home, there are special rules, which are detailed in Publication 587.
Be aware, also, that if the gross income from your business is less than the deductions (including office-in-home), some of your deductions may be limited. If you use the general method, rather than the simplified method, some of the deductions may be carried forward to the next year. Again, details are in Publication 587.
If you are an employee maintaining an office at home for the convenience of your employer, you can take the deduction as an unreimbursed employee business expense on Schedule A. For instructions about how to do that, see the Instructions for Schedule A. Keep in mind that the deduction is subject to the 2% of Adjusted Gross Income floor.
Another reminder: If you are using the general method, and you are including expenses that are otherwise deductible as itemized deductions on Schedule A (such as mortgage interest, property taxes, and mortgage insurance premiums), the percentage of those indirect expenses not used on Form 8829 are still deductible on Schedule A. For instance, in the example above, 10% of the mortgage interest of $14,400 (or $1,440) is deductible on Form 8829. The other 90%, or $14,400 – $1,440 = $12,960, can be deducted as mortgage interest on Schedule A.
The home-office deduction can save you a substantial amount in taxes. If you are a small business owner wanting to cut costs, start early to assemble your receipts, utility statements, mortgage statements, or cancelled rent checks to calculate and justify your deduction for a home office. Reducing your business’s net profit not only reduces your income tax, but also your self-employment tax.
Be sure to check out our related articles: tax deductions for self-employed freelancers and small business owners, deductions for job-related and job-seeking expenses, and tax deductible job relocation moving expenses.
Do you run a business from home? What other tax deductions do you take advantage of?