If you’re a small-business owner, freelancer, independent contractor, or self-employed person who maintains an office at home, 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. 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.
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
“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.
Pro tip: By using tax preparation software from a company like H&R Block, you’ll have confidence you’re getting every available tax deduction and minimizing your tax liability.
Home Expenses That Count Toward the Deduction
IRS Publication 587 notes that allowable office-in-home expenses are of three kinds:
- Direct expenses apply to the office only (for example, repainting the office).
- Indirect expenses apply to the entire home (for example, utilities).
- Unrelated expenses apply to neither the office nor the home itself (for example, lawn care).
Direct expenses can be deducted on your tax return in whole. Indirect expenses are deducted proportionately, according to the office square footage compared to the square footage of the total house; 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 expenses. 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 Your Home Office Deduction
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 the part of your home used for business activity is a room that’s 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
- Total: $21,000
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 homeowners to deduct an amount for the wear and tear from normal use of the property over its useful life of. 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, 2109
- 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 actual expenses and maintain proper records in the event of an audit. To make it easier for taxpayers, the IRS allows 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 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 & 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.
Another reminder: If you’re using the general method, and you’re including home office 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 tax deduction can save you a substantial amount in taxes. If you’re a small-business owner wanting to cut costs, start early to assemble your receipts, utility statements, mortgage statements, or canceled 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.