Taking the home office deduction can be complex and vary between individual small businesses. For more information on whether you should take the home office deduction, please consult with your licensed CPA.
Many small businesses are based at home. There are numerous stories about large and successful businesses getting their start around the kitchen table or in a garage. The reason for this is primarily financial – the business owner doesn’t have to pay rent for often expensive office space, especially if much of the work can be done at home. Working from home is both popular and necessary these days and there can be some tax benefits available under the right circumstances.
Ordinary and Necessary Business Expenses
Many small business owners ask where their fancy tax deductions are now that they are in business. They hear that many large businesses get lots of write-offs and pay little in taxes. The first thing any taxpayer should always do is not judge their tax situation on someone else’s tax situation. You have no idea what that other taxpayer is doing or how it might be relevant to your business. Small business deductions vary for every individual business.
Deductions are amounts a taxpayer can deduct from gross income to determine taxable income. So, a deduction will reduce your taxes at a certain percentage (your marginal tax rate*) for each dollar spent. For example, if your marginal tax rate is 12%, each dollar you spend on a business expense will reduce your taxes by 12 cents.
It is always important to evaluate every transaction you enter into to make sure that it makes good business sense. Otherwise, you are simply spending (in the example above) a dollar to save 12 cents.
All businesses are entitled to deduct all ordinary and necessary expenses of operating a trade or business. This often allows them to deduct expenses that an ordinary taxpayer that doesn’t own a business can’t. There are several examples, but the focus here will be on the home office deduction.
What Are the Rules for a Home Office Deduction?
The Internal Revenue Service (IRS) is clear on this. On their website (irs.gov) they specify who can take the deduction, the qualifications for taking the deduction, and the methods for taking the deduction.
The IRS says:
If you use part of your home for business, you may be able to deduct expenses for the business use of your home. The home office deduction is available for homeowners and renters and applies to all types of homes.
So, if you live in a mobile home, for example, and you run your business from there, you are entitled to deduct certain expenses of owning that mobile home. The deduction does not apply if you work at home as part of your job, although your employer may reimburse you for the cost of working at home.
There are very specific requirements for taking this deduction, however. Again, from the IRS website:
There are two basic requirements for your home to qualify as a deduction:
- Regular and exclusive use.
- Principal place of your business.
Both requirements must be met to take the deduction.
Regular and exclusive use means just what it says. The space used must be used only for business. For example, a plumbing or air conditioning business that uses a room or part of a garage to store parts for use in the business would get a deduction for that part of the home used for that purpose. Likewise, a room used in a home specifically for administrative or other business purposes such as meeting clients would also qualify.
But what about a kitchen table used to run a business. This is difficult because the table may also be used to eat meals, which clearly do not have a business purpose. Or a room where some business is conducted but is also used for rest and relaxation, such as watching TV. Business is not the only use. The IRS clearly states that this would not qualify for the deduction.
Principal Place of Business
If the space meets the exclusive use requirement, then it must also be used as the principal place of business to qualify for the deduction. If the business rents office space the home office deduction will most likely not be allowed.
The rule is dependent upon where the majority of business activities take place. For example, if a business uses the home for all administrative and operational functions but also rents space in an executive suite at another location to just meet clients or collect mail, the home office deduction would probably be allowed, assuming all other conditions regarding use described above are met.
How is the Deduction Taken?
The home office deduction is generally only deductible by sole proprietors or single-member LLC’s taxed as a sole proprietor on their Form 1040 Schedule C. There is a separate form (Form 8829) that has to be filled out that records the allowed expenses and calculates the deduction. There are provisions for partners or employees of S-Corporations to take the deduction but there are special rules that apply to each which are beyond the scope of this discussion. Please consult a tax or small business professional such as a Certified Public Accountant (CPA) or Enrolled Agent (EA) if you are involved with those types of entities for more information.
The IRS allows two methods for determining the deduction.
Actual Expenses. There are three types of expenses related to your home, some of which are fully deductible, some partially and some not at all.
- Fully deductible expenses are limited to those items that directly affect the space itself, such as repairs and maintenance to the office.
- Partially deductible expenses include items that benefit the entire home such as insurance, utilities, mortgage interest and property taxes. The deduction is based on the percentage of the home used for business purposes and the percentage is determined by square footage of the space in relation to the total square footage of the home. For example, if the office space is 100 square feet and the house is 1000 square feet, the deduction would be 10 percent of these expenses. Keep in mind that expenses like mortgage interest and real estate taxes are also allowed as itemized deductions so an allocation between business and personal deductions must be made based on the percentage.
- Nondeductible expenses included items that have no relation to the space. An example would be landscaping.
Actual expenses also make provision for depreciation of the home itself, again subject to the percentage used for business purposes. Depreciation is a topic by itself and beyond the scope of this discussion, but be aware that, while this can be a relatively significant deduction, if you take it as part of actual expenses and you sell the home in the future, you will have to recapture the depreciation deducted in past years as income. Tax planning with a professional is crucial in this situation.
Actual expenses are also limited in their deductibility based on the gross income of the business and involve a less than simple calculation. If the deduction is limited, it can be carried forward to the following year.
Taking actual expenses involves a large amount of record keeping or bookkeeping, including gathering receipts to support the deduction. If the IRS audits your tax return, there must be detailed support for the deduction, or it will be disallowed.
Home Office Deductions Simplified
To avoid all the recordkeeping involved with actual expenses, the IRS allows a taxpayer to deduct an amount based on a simple calculation. The rules for qualifying for the deduction mentioned above still apply, but the amount is determined by multiplying the square footage of the space by $5 and is limited to 300 square feet or $1,500. No depreciation is allowed under this method and there is no carryforward of unused amount, but it is definitely easy to use, again, if the space qualifies.
A taxpayer is allowed to choose which method, actual or simplified, will provide the best deduction each year but it cannot be changed within that year, for instance, if a return was subsequently amended.
No one really knows, with the exception of the IRS, how a tax return is selected to be audited. It could be random, and it could be due to a red flag on a tax return. Many tax professionals would agree that the home office deduction has a better than average potential for abuse, knowingly or innocently, and is probably a red flag.
Certainly, if a return is audited and the home office deduction has been taken, the records need to be complete and in order and it must be clear that space meets the two requirements for use and place of business or the deduction will be disallowed.
Taxpayers should look at the potential tax savings of this deduction in relation to the time and effort required to make sure space qualifies, the recordkeeping is in order, and the potential costs of selling a home that takes this deduction in the future. It is often not cost beneficial. The simplified method probably is, but the use requirements still have to be met and that is the real determination whether this deduction makes sense.
Final Words on Home Office Deductions
IRS Publication 587 Business Use of Your Home details the complete rules for taking this deduction. It is 35 pages long and has detailed instructions and worksheets on how to take the deduction. This discussion has merely scratched the surface. It is a complicated topic that is best discussed with a tax or business professional such as a CPA or EA.
*The marginal tax rate is not the rate of tax you pay, it is the amount of tax you pay on the next dollar you earn because there are several tax brackets based on income.
Schedule a free consultation with a professional CPA to discuss your small business deductions.