Tax Deductions for a Home Office: Are You Eligible?
Thursday, February 09, 2017
Millions of people now work from home and some reports show that more than 50% of businesses in the United States are being run from home offices. This article will address tax issues related to the business use of a home – specifically, who may deduct such expenses and what expenses are deductible.
Who May Deduct Home Office Expenses
- Individuals who work at home fall into one of two categories – self-employed individuals and employees.
- Self-employed individuals may deduct the expenses of a home office provided that:
- A specific area of the house is used exclusively and regularly for conducting business
- The home office is the principle place of business
Exclusive and Regular Use
Part of the home must be used exclusively for business. You cannot deduct expenses for any area that is used for both business and personal purposes. Therefore, using the family room or kitchen table for business will not qualify.
The home office must be used for the conduct of a trade or business. Not all profit-seeking activities qualify. For example, the use of a room to manage investments will not qualify because the activity is not a trade-or-business regardless of the amount of income.
The home office must be used regularly for the conduct of the business. Incidental or occasional use will not qualify.
Principal Place of Business
The home office must be the principle place at which the business is conducted. To meet this requirement the following factors are considered:
- If the home office is used for the administrative or management activities of the business and there is no other fixed location where such activities are conducted, the home office expenses will be deductible.
- If there is another location at which some administrative or management activities are conducted, the relative importance of the activities performed at each location is considered
- If there is another location at which some administrative or management activities are conducted, the amount of time spent at each location is considered
- If the home office is used to meet customers or clients, the expenses of the home office are deductible. This is the case even though business is carried on at another location and even though the location at home where such meetings occur is not the principal place of business. But the use of the home for such meetings must be substantial and integral to the conduct of the business
Employees Working at Home
An employee who works at home may qualify to deduct the expenses of a home office if the following additional tests are met:
- The business use must be for the convenience of the employer
- No part of the house may be rented to the employer
It is important to note that the deductible portion of an employee’s business expenses is reduced by 2% of the individual’s adjusted gross income.
Calculation of Expenses for the Home Office
Expenses that are deductible fall into 3 categories:
- Direct expenses of the business that would be incurred regardless of where the business activities are conducted
- Expenses of the home that are directly related to the portion of the home used for business
- Expenses of running the entire home that are allocated to the home office
Direct Expenses
Direct expenses are those that would be incurred for the business regardless of where the business is located. Examples include wages, business insurance, stationery, supplies and computer equipment. Technically, these are not home office expenses but are included here to be sure that they are not missed.
Expenses of the Home Directly Related to the Home Office
Certain expenses of the home are directly related to the home office and are deductible in full. They include improvements, repairs and painting of the space used exclusively for business and the costs of a telephone used exclusively for business.
Expenses of Running the Entire Home
Some of the expenses of running a home may be allocated to the home office. Examples include rent, electricity, fuel, mortgage interest, real estate taxes and depreciation. The two methods of calculating the amount of such expenses that can be deducted are:
- Allocation based on the amount of space used for business
- Simplified method
Allocation of Expenses
The amount of the expenses of running a home that can be allocated to a business is based on the percentage of space used for business. For example, if the space used exclusively for business is 300 square feet and the total area of the house is 3,000 square feet, then 10% of the home expenses are deductible as business expenses.
Simplified Method
In order to avoid having to track expenses of running the home, the Internal Revenue Service has provided a simplified method to calculate the amount of expenses that are deductible. The amount of the deduction is calculated by multiplying the square footage of the space used for business by $5.00. For example, if the area used for business is 200 square feet, the deductible expense is $1,000.
The area used in this calculation may not exceed 300 square feet. Therefore, the maximum deduction allowed using the simplified method is $1,500 (300 square feet multiplied by $5).
Note that actual expenses and depreciation are not deductible if the simplified method is used.
Gross Income Limitation on Deductions
The deduction for business use of the home may not exceed the gross revenue derived from the business reduced by direct expenses.
Example 1
Assume that the gross revenue from a home office is $30,000 and direct expenses (wages, contractors, stationery, dues, equipment, etc.) total $25,000. In this case the amount of home office expenses that is deductible is limited to $5,000. Expenses over that amount are not deductible but are carried forward to the following year.
Example 2
Assume that the gross revenue from a start-up business is $10,000 and direct expenses (wages, contractors, stationery, dues, equipment, etc.) total $15,000 resulting in a loss of $5,000. In this case the amount of home office expenses that is deductible is limited to zero. Otherwise deductible home office expenses incurred may be carried forward to the following year.
The gross income limitation presents an important issue. If the allocation method is used to calculate allowable expenses, a portion of mortgage interest and real estate taxes are allocated to the business. If the amount of deductions is limited by gross income, some of the interest and real estate tax expense will not be deductible in the current year. If the simplified method had been used, all of those expenses would be deductible as personal itemized deductions. Therefore, care should be taken when choosing which method should be used for a business that had a net loss.
Red Flags
There is a form that has to be attached to an individual’s tax return if he or she deducts the expenses of a home office. Some people believe that taking such deductions is a “red flag” and attracts scrutiny from the Internal Revenue Service. The author disagrees. Home offices are common and no longer “stand out”. So, take the deductions if you are eligible and save taxes.