A home office can allow you an amazing deduction on your business tax return, reducing your total taxes paid. Best of all, it converts certain traditionally non-deductible personal expenses into deductible business expenses. Essentially, it lowers the taxes you pay without costing you any money. It sounds like the perfect expense! Many business owners miss claiming or not fully utilizing a home office expense. Not to worry! We will help ensure you never become part of that crowd. Read through the information below to better understand the home office deduction and read about an alternative option at the end.

Step 1: Verify You Qualify

The first step is to verify that you qualify for a home office deduction. To incorrectly claim the deduction without properly qualifying could cause tax audits along with penalties and interest being due to the IRS. Get this right before causing future headaches down the road.

You must own a business

Years ago, employees could qualify for the home office deduction but this was taken away in 2017 by the Tax Cuts and Jobs Act (TCJA). Now, only business owners can qualify for the deduction. Don’t forget: subcontractors are business owners too!

You must be paying for a permanent residence

You can be a homeowner or a renter and the type of home can vary: single-family homes, apartment complexes, houseboats, and so on. The residence must be permanent so hotels or other temporary lodging do not count.

A qualifying space must exist

This one may sound straightforward but it can be tricky. You need to have a set space in your home that is being used. This can be a small or large room, a basement, and so forth. It can even be a separate structure such as a garage or barn.

In addition, the location must pass two tests. The first test is “Regular and Exclusive Use”. This means the room must be used solely for the business and nothing else. It cannot be your kitchen table or the children’s playroom - it can only be used for business purposes.

The second test is “Principal Place of Business”. While your home office doesn’t have to be your only work location, it does need to be the principal one. This means you use the space exclusively for most of your business tasks: administrative, management, bookkeeping, sales, etc. If you split your time between your home office and a separate office location, then your home office does not qualify for the deduction. The home office does not qualify if it’s simply helpful. Be careful of this test - many business owners do not realize they fail the test. Get in touch with our office and we can help!

Step 2: Calculate the Deduction

Now that you verified your home office qualifies for the deduction, you need to calculate the amount. There are two methods you can utilize to calculate your deduction: the simplified method and the regular method.

The simplified method is just that: it’s simple. First, determine the square footage of your home office. Multiply the total square footage, but no more than 300, by $5 per square foot. The result will be your potential deduction.

The regular method requires more calculations but almost always provides a better deduction than the simplified method. Determine the total expenses paid toward your home for the following categories paid in the tax year:

Mortgage interest
Real Estate Taxes
Rent
Mortgage Insurance Premiums
Home/Renter’s Insurance
Utilities (such as electricity, gas, water, disposal)
Security System
Maintenance and Repairs (separate items related to the office and related to the home)

Note that repairs must not be improvements or they do not qualify. Determine the total square footage of your home and your office. Divide the office square footage by the home square footage. For example, if your home is 2,000 square feet and your office is 200 square feet, then the result would be 10%.

Multiply the total indirect expenses by your square foot percentage. Add the result to any direct maintenance and repair expenses related to the office. Multiply this amount by your square footage percentage (10%) and add the direct expenses.

In the example, the total potential deduction is $1,430.

Step 3: Retain the Receipts

As with all other business expenses, you must maintain your receipts as proof of the expenses you paid if you use the regular method. This includes all of your utility payments, your repairs, and all other related expenses. We recommend you sign up online with your vendors so you can download each statement every month. Set reminders for yourself so you obtain these records as the year progresses rather than waiting until the end of the year. You don’t want to lose out on access to statements because a vendor merged with another company or sold your home loan.

Special Situations Regarding Your Home Office

There are important situations to consider before deducting your home office expenses. Understand the below items before taking the deduction to avoid any costly mistakes.

Daycare facilities have special calculations

Daycare facilities allow for unique calculations and lesser restrictions to benefit the business. For example, an area of the home may be deductible if it is used for daycare purposes even if the space is also used for non-business purposes. Special restrictions can apply.

Selling your home

When selling one’s home, you may qualify for an exemption on the profit of the sale. This is common so many taxpayers do not realize there are situations where the profit could be taxable. When you utilize the regular method for calculating your home office expense deduction, you will be taking advantage of depreciation for your home office. Depreciation is a type of deduction that accounts for the wear and tear of the property over time. When selling your home, the portion of the home that was your office will be excluded from the tax exemption and may be taxable. For example, if your office is 15% of your home, then 15% of the profit when selling your home may be subject to capital gains tax.

This may sound scary but first remember that the tax applies to the profit of the sale, not the total sale amount. Additionally, if all of the below conditions are met, you may qualify for not taxing the office-related portion of your home at the time of its sale:

You were not using the space for business or rental at the time you sold the property,
You did not earn any business or rental income from the space in the year you sold your home, and
You used the space as residence space for 2 years out of the 5 years leading up to the sale.

Deduction Limitation

A deduction for your home office cannot exceed the profit your business had. Fortunately, any amount greater than your profit can be rolled over to the following tax year. In the below example, the business’s profit is reduced to $0 and a remaining $2,500 deduction can be used in the following tax year if the business is still in operation and has available profit to apply against.

Alternative: Give Us a Call Instead

Business is complicated enough. On top of maintaining your sales, your quality of work, and your staff, the last thing you need to worry about is how to calculate a complicated tax deduction. We take the accounting and tax work off of your plate and let you do what you do best: run your business.

We review the home office requirements with our business clients to see if you qualify. We do this every year in case something has changed. We then help you track any related expenses and will handle all of the calculations. Since we look at the entire picture of your business and its impact personally, we can plan ahead for a home sale to minimize or eliminate any taxes you may owe because of your home office. Contact us today to get started!

This post is to be used for informational purposes only and does not constitute legal, business, or tax advice. Each person should consult his or her own attorney, business advisor, or tax advisor with respect to matters referenced in this post. Level Books assumes no liability for actions taken in reliance upon the information contained herein.

Taking Advantage of a Home Office