Home Office Deduction

A self-employed taxpayer may be able to deduct the cost of a home office if the space allocated to the office is used exclusively and regularly for the taxpayer's business and it is the taxpayer's principal place of business, meaning that the taxpayer works there most of the time or that most of the business income comes from activities performed at the home office. However, if a worker regularly uses a home office for the administration or management of activities for a business, then the business can take the home office deduction even if most of the business is conducted outside. A married couple can each claim a home office deduction using different parts of the home if they each qualify for the home office deduction and their businesses are separate.

A home office deduction may also be claimed for space allocated for storing inventory, including product samples as long as the space is used regularly for such purposes and that the space is identifiable and suitable for the storage.

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An employee can also claim a home office deduction. However, all of the rules that are required of the business owner claiming the deduction also apply to the employee, but the employee must also satisfy an additional rule that the use the home office is for the convenience of the employer, not the employee. Although an employee can deduct the same expenses as a business owner, they must be reported on Form 2106, Employee Business Expenses as a miscellaneous deduction subject to a 2% AGI floor. So if an employee has an AGI of $100,000, then only miscellaneous deductions that exceed $2000 can be deducted. Because of this floor, an employee should not claim any mortgage interest or real estate tax as a miscellaneous deduction, since those deductions can be reported as deductible personal expenses not subject to the 2% AGI floor on Schedule A, Itemized Deductions.

Although calculating the home office deduction is not difficult, there is a home office safe harbor provision that simplifies calculating the deduction, and probably makes it less likely that the taxpayer will be audited because of the deduction, since the safe harbor deduction is limited. However, the safe harbor provision may save more taxes than deducting actual expenses if the business area is small compared to the total area of the home.

Home Office Space

Regular and exclusive use requires that the place of business is used to meet or deal with patients, clients, or customers — occasional meetings do not qualify. Administrative or managerial activities also qualify for the home office deduction if the office is used regularly and exclusively for such activities and the self-employed taxpayer has no other fixed location where he does substantial amounts of administrative work. Actually working in the home office, as a writer would, also qualifies.

Administrative or management activities qualify even if the taxpayer sometimes conducts business from a hotel room or from his car. Nor must all of such activity be conducted from the office. For instance, the taxpayer can outsource billing to a company that specializes in billing services. Even if the taxpayer has a suitable space to work outside the home but chooses not to, the home office deduction can still be claimed.

The business area must be used exclusively for the conduct of one or more businesses. It cannot be used for a nonbusiness purpose. If the taxpayer uses the home office for more than one business, then each business must satisfy the test for deductibility of the home office; otherwise the IRS may disallow deductions even for the business that would ordinarily qualify, because the area is not being used exclusively for the qualified purpose.

A partition or physical separation of the office is no longer required, but it may be helpful in making the business area readily identifiable during an audit. A separate structure, such as a studio or room can also be used as a principal place of business, but it must also satisfy all the tests for a home office deduction. Some taxpayers have tried arguing that a separate structure was not subject to the same rules as a home office because of its separateness. However, the IRS and the tax court looks at the following clues to see if there is an important distinction:

The deduction of rent, interest, depreciation, and utilities depends on the business use percentage, which is the size of the business area compared with the rest of the residence. There are 2 methods for determining this ratio. The first method, which is most common, is to divide the number of square feet used for the office divided by the square footage of the house:

Formula to Calculate the Business Use Percentage
Business Use Percentage =Business Area
Area of Home

If the rooms of the house are all approximately the same size, then the business use percentage can be determined by dividing the number of rooms used in the business divided by the total number of rooms.

Taxpayers that provide day care services for the caring of children, handicapped people, or persons age 65 or older can also deduct the business use of their home for their day care service if they satisfy state licensing requirements. Unlike for other businesses, the area used for the day care services does not have to be used exclusively for business; it only has to be used regularly for business. However, because the area does not have to be used exclusively for business, the deduction is not only limited to the square footage of the business area divided by the square footage of the home, but it is also limited by the number of hours that it is used as a day care facility per year divided by the number of hours in the year, which is 8,760 hours:

Formula for Calculating the Business Use Percentage for Day Care Services
Business Use Percentage for Day Care Services =Business Area
Area of Home
×Day Care Hours
Hours in Year (8,760)

So, for instance, if the taxpayer had $10,000 of deductible expenses attributed to the use of the area (indirect expenses) for a day care facility that was used for 3,000 hours annually, and where 1000 ft.² of a 2000 ft.² house was used for the day care facility, then the deductible expense would be limited to: $10,000 × ½ × 3000/8760 hours = $1,712.33.

Although sideline businesses can qualify for the home office deduction, if they satisfy all the other tests for the home office deduction, a deduction cannot be claimed for management of investments, unless the taxpayer is a professional trader, who makes most of his income from short-term trades. Indeed, if the taxpayer does have a sideline business that would otherwise qualify for the home office deduction, then using the space for managing investments would disallow any deduction at all, because it would not be used exclusively for the qualified business.

Home Office Expenses

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Deductible home office expenses include mortgage interest, operating expenses, such as utility costs and home insurance premiums, real estate taxes, depreciation of the business area, and even the cost of domestic help. The deductibility of such indirect expenses is limited to the business use percentage. So, for instance, if the business use percentage is 25%, then 25% of indirect expenses, such as for electricity and gas, is deductible.

Formula to Calculate the Indirect Expense Deduction for a Home Office
Home Office Indirect Expense Deduction = Total Indirect Expenses × Business Use Percentage

Direct expenses, which are expenses that affect only the office, such as repairs in the office, are fully deductible. Likewise, expenses that do not affect the business area at all are not deductible — not even the business use percentage. So repairing the roof or painting the outside of the house is deductible according to the business percentage use, but landscaping or yard work is not deductible at all.

The initial expense of a security system is depreciable, while periodic maintenance fees are also deductible.

Property Depreciation

Depreciation of the home office area is generally calculated as if it was a commercial property, using the 39 year recovery period. The tax basis of the home office uses the lower of the fair market value (FMV) of the house when the business was started or its adjusted basis without regard to the land, since land is not depreciable.

For instance, if you bought a house for $100,000 in 1990 and it is now worth $200,000, and use 25% of the area for your business, then you must use the lower adjusted basis of $100,000 multiplied by the business percentage to yield the cost basis for the business area, which is $25,000. This product must then be multiplied by the percentage, which is determined from IRS depreciation tables for nonresidential real property. So if you began business in January, then the percentage is 2.461% for 2011 for the first year, so this must be multiplied by the depreciable basis of $25,000, which yields a first-year deduction of $615.

  1. Tax Basis = Lower of FMV or Adjusted Basis
  2. Tax Basis of Home-Office = Tax Basis × Business Percentage of Home
  3. Depreciation Deduction = Tax Basis of Home-Office × Depreciation Percentage

Depreciation may also be taken for cooperative apartments. If the taxpayer is the first owner of the apartment, then the depreciation is equal to the percentage of the stock interest that he owns, reduced by the amount of space allocated to commercial tenants who do not own stock interest in the cooperative. If the taxpayer buys the stock from a previous owner, then the depreciable basis depends on the price of the stock and the share of the co-op's outstanding mortgage, reduced by the percentage of land and commercial space of the cooperative.

A disadvantage of claiming a home office for homeowners is that if the home office is depreciated, then that depreciation will have to be recaptured when the home is sold, even if the home sale exclusion would otherwise make the gain on the residence tax-free. So if the taxpayer deducted $10,000 for the depreciation of the home office, with a business usage percentage of 20%, then $10,000 × 20% = $2000 must be added back to income in the year of the sale. So if the taxpayer has a 25% marginal rate, then an additional $500 in taxes will have to be paid.

Note that the maximum long-term capital gains rate on un-recaptured §1250 property, which is real property for which depreciation has been claimed, is 25%, which also applies to recaptured depreciation on a home office. Furthermore, in contrast to regular depreciation rules, if the homeowner failed to claim depreciation for which he was entitled, then only the amount that was actually deducted must be recaptured. If the simplified method for calculating the home office deduction was used, then there is no depreciation recapture.

Calculating the Home Office Deduction

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The home office deduction is figured on Form 8829, Expenses for Business Use of Your Home, which yields a single deduction that is carried over to Schedule C. The home office deduction is limited to the net income generated by the business before the home office deduction is taken. This means that other business expenses that are direct business deductions must be deducted first, such as the expenses for supplies or for car and truck expenses. Any unused deduction can be carried forward.

Form 8829 consists of 4 parts:

  1. Part 1 calculates the space allocated to the business use.
    1. Business Percentage = Business Use Area ÷ Total Area
      1. For day care providers, Business Percentage = Business Percentage × Daycare Days × Daycare Hours per Day ÷ Total Hours in Year
  2. Part 2 provides for the reporting of direct expenses + allocated indirect expenses for the business use.
    1. Enter Tentative Profit from Schedule C
    2. Subcalculations of either the whole amount of direct expenses or the business percentage of indirect expenses:
      1. Casualty Losses +
      2. Deductible Mortgage Interest +
      3. Real Estate Taxes
      4. = Total Nonbusiness Deductible Expense
        1. Homeowners can deduct the above expenses whether they have a home office or not. However, these expenses must be deducted 1st from the tentative profit to determine the upper limit for the remaining expenses for the applicable tax year. Any unused expenses can be carried forward.
      5. Excess Mortgage Interest +
        1. This is any qualified home mortgage interest or mortgage insurance premiums that could not be deducted on Schedule A, but where the nondeductible portion qualifies as a direct or indirect expense for the business.
      6. Insurance +
      7. Rent +
      8. Repairs and Maintenance +
      9. Utilities +
      10. Other Expenses
      11. = Total Deductible Expense from Business Use of Home
    3. Deductible Indirect Expenses = Total Indirect Expenses × Business Percentage
    4. Total Operating Expense Deduction = Direct Expenses + Deductible Indirect Expenses
    5.  From the Tentative Business Income from Schedule C, subtract the following:
      1. Total Nonbusiness Deductible Expense
      2. Total Operating Expense Deduction
      3. Carryover of Operating Expenses from the Previous Year
      4. Deductible Excess Casualty Losses
      5. Depreciation (calculated in Part 3)
      6. Carryover of Excess Casualty Losses + Depreciation from Previous Year
      7. = Allowable  Deduction for Business Use of Home
    6. Note that if above result < 0, then the negative portion of the result must be carried forward in Part 4.
  3. Part 3 calculates the depreciation of the business area. If the taxpayer pays rent, then the rent is deductible as an ordinary expense, but there is no depreciation since the taxpayer does not own the residence.
    1. Basis of Home = Lesser of Adjusted Basis or Fair Market Value – Value of Underlying Land
      1. Land is not depreciable, so its value is subtracted from the total value of the home.
    2. Business Basis of Home = Basis of Home × Business Percentage
    3. Allowable Depreciation = Depreciation Percentage × Business Basis
      1. The depreciation percentage can be found in Part III, Line 40 in Instructions for Form 8829, Expenses for the Business Use of Your Home.
  4. Part 4 allows for the carryover of disallowed deductions because of the income limitation as determined in Part 2. Unused operating expenses and excess casualty losses plus depreciation are carried forward separately.