Don’t shy away from the home office deduction because you heard that it is a “red flag”. Our experience has been that, if you have a qualified home office and report your expenses properly, there is nothing to worry about. In fact, the IRS has even made it easier to compute the deduction.
Can you deduct Home Office expenses?
To qualify for the home office deduction, two general conditions must be met:
1) The area must be used exclusively and regularly for business. (Note: It does not have to be a full room. It can be part of a room but it must meet these conditions). Exclusively means for business only – not for personal purposes, such as watching TV, sleeping, playing, etc. The use has to be part of your normal business conduct, not just occasional.
2) It must be either:
a. your principal place of business (i.e. where you work most of the time) OR
b. where you meet with customers, clients or patients
c. where you perform significant business functions, such as administration, as long as there is no other place available to you.
(A) A self-employed plumber’s home office is not his principal place of business because he spends most of his time elsewhere. But since he uses a portion of his house exclusively and regularly for tracking jobs and billing customers, it qualifies for the deduction.
(B) A self-employed attorney has his office in town but on weekends and evenings often meets clients in an office in his home. It is not his principal place of business but because he meets with clients there and there is no other use of that room, it qualifies.
(C) I have an office in Mount Kisco. I also use an office in my home exclusively and regularly for my CPA and CFP practice but I do not meet clients there. Since I have another place of business, my home office does not qualify.
If you use a separate structure on your property exclusively and regularly, it does not have to meet the second condition.
If you are an employee, your employer must require you (not merely allow you) to work from home. It must be for the good of your employer, not your convenience. For example, your employer does not provide you with a place to work and requires you to work from home.
If you operate a licensed day care center or if you are legally exempt from licensing, you do not have to meet the condition of exclusivity but the area you claim must still be used regularly.
If your business involves selling products and you use part of your home to store inventory or samples, you do not have to meet the exclusivity test but your home has to be your only place of business.
If you do not conduct a trade or business, you do not qualify. For example, if you use your room for managing your portfolio, you do not qualify unless you are an investment broker.
What expenses are deductible?
Direct Expenses – Expenses that can be directly identified with home office use, such as shelving, office carpet or installation of a telephone line, are fully deductible.
Indirect Expenses – These are expenses that have mixed use such as rent, mortgage interest, real estate taxes, utilities, home owner’s insurance, security system, repairs, snow plowing, lawn care, garbage collection, etc. They must be pro rated between business and personal based on the square footage of the office and the total square footage of the home. Depreciation is also a pro rated, indirect expense and is based on the cost of the house plus improvements (more on depreciation below). Any mortgage interest and real estate taxes that are taken as home office expenses may not also be taken as Itemized Deductions.
Limits – If you are self-employed, you cannot deduct home office expenses if the deduction will create a loss or increase a loss. You can however carry over the loss to be used next year. If you are an employee, the deduction counts as a Miscellaneous Deduction subject to 2% of your Adjusted gross income.
What happens when you sell the house?
If you sell your house at a profit, you will not be taxed on up to $250,000 of profit ($500,000 on a joint return) as long as the house qualifies as your personal residence. Generally this means that the house was your primary residence for 2 out of the last 5 years. But if you used part of your house exclusively for business, you will have a taxable gain equal to the total of all the depreciation taken since May 6, 1997. (How do they come up with this stuff?) For example, let’s say you sell your qualified residence at a gain of $50,000 and suppose all of the depreciation you have taken on the home office since May 6, 1997 comes to $2,000. You will have a $2,000 capital gain.
If your home office is a separate structure, you must pro rate the gain between the residence and the office. You can only exclude the gain on the residence.
Is it worth it?
If you clearly meet all the qualifications for a home office and you have the expenses well documented, then by all means, it is worth it. Here’s why :
You get to deduct many expenses that would otherwise be non-deductible. Plus you get to deduct them not only for income tax, at whatever bracket you are in, but also for self-employment tax. If/when you sell in the future, the “give back” mentioned above is only a small part of what you deducted and it is taxed more favorably than ordinary income.
However, it’s not a good idea to try to deduct the guest bedroom or the basement that is also a playroom. It has to be exclusively used for business.
A Simplified Option for Claiming Home Office Deduction
You have the option of using the above method for calculating direct and indirect home office expenses or a new simpler method.
The new optional deduction is a flat $5 per square foot for up to 300 sq feet so it is limited to $1,500 per year. You can still claim all of your mortgage interest and real estate taxes as an Itemized Deduction. This simpler method will reduce the paperwork and record keeping requirements but if you want to compare the two methods and use the older one, you will still need those records.
This only changes how you calculate the deduction. It does not change the conditions that must be met to qualify for it.