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Home Office Tax Deductions for Small-Business Owners

June 2, 2017
Income Taxes, Small Business, Taxes
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Small-business owners, entrepreneurs and employees who work from home could save big money on their taxes by taking a home office deduction, as long as they meet the IRS’ requirements and keep good records.

If you use part of your home regularly and exclusively for business-related activity, the IRS lets you write off associated rent, utilities, real estate taxes, repairs, maintenance and other related expenses.

Here’s what small businesses should know about the home office deduction.

How to determine eligibility

How to determine your deduction

Simplified method vs. actual expense deduction

Things to watch out for.

How to determine eligibility

You can claim the deduction whether you’re a homeowner or a renter, and you can use the deduction for any type of home where you reside: a single-family home, an apartment, a condo or a houseboat. You can’t use it for a hotel or other temporary lodging.

The home office deduction rules also apply to freestanding structures. You can use a studio, garage or barn space as your home office as long as the structure meets the “exclusive and regular use” requirements.

Here are the conditions you’ll need to meet:

Regular and exclusive use: The space you’re using for business must be used exclusively for conducting business. For example, using a spare bedroom as both your office and a playroom for your children makes you ineligible.

“An extra bedroom works, as long as you don’t use it for guests, even a few days a year,” says Johanna Fox Turner, an accountant and certified financial planner in Mayfield, Kentucky.

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Principal place of business: Although your home office doesn’t have to be the only place you meet your clients or customers, it must be your principal place of business. That means you use the space exclusively and regularly for administrative or management activities, such as billing customers, setting up appointments and keeping books and records, according to the IRS.

There are two exceptions to the exclusivity rule. If you provide day care services for children, elderly (65 or older) or handicapped individuals in that part of the house, you can still claim business deductions, as long as you have a license, certification or approval as a day care center under state law, according to the IRS.

The other exception is if you use the office for storage of inventory or product samples you sell in your business.

If eligible, you can deduct home business expenses using a Form 8829, and the amount is then reported on a Form 1040.

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How to determine your deduction

You can determine the value of your deduction the easy way or the hard way.

With the simplified option, you aren’t deducting actual expenses. Instead, the square footage of your space is multiplied by a prescribed rate. The rate is $5 per square foot for up to 300 square feet of space. If your home office is over 300 square feet, you can’t use the simplified method.

» MORE: Best tax software for the self-employed

The regular, more difficult method values your home office by measuring actual expenditures against your overall residence expenses. You can deduct mortgage interest, taxes, maintenance and repairs, insurance, utilities and other expenses.

The IRS introduced the simplified option beginning in the 2013 tax year, because the regular method requires accurate record-keeping that may be burdensome for some small-business owners and entrepreneurs.

You can use Form 8829 to figure out the expenses you can deduct and file only with Schedule C (Form 1040).

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Simplified version vs. actual expense deduction

The choice whether to use the simplified deduction, if you’re eligible for it, or to deduct actual expenses depends mainly on which would net you the bigger tax deduction.

If you use the actual-expenses method, you can deduct direct expenses — such as painting or repairs solely in the home office — in full. Indirect expenses — mortgage interest, insurance, home utilities, real estate taxes, general home repairs — are deductible based on the percentage of your home used for business.

Office interior.

Example: Let’s say you paid $3,000 in mortgage interest, $1,000 in insurance premiums and $3,000 in utilities (all indirect expenses) plus $500 on a home office paint job (direct expense) in the 2016 tax year. Your home office takes up 300 square feet in a 2,000-square-foot home, so you’re eligible to deduct indirect expenses on 15% of your home.

You’d be eligible to claim a deduction of $1,050 in indirect expenses ($7,000 in expenses, multiplied by the 15% of space used in the home), plus $500 for the direct expense of painting the home office, for a total deduction of $1,550.

» MORE: 5 overlooked tax deductions for 2017

If your home office is 300 square feet or less and you opt to take the simplified deduction, the IRS gives you a deduction of $5 per square foot of your home that is used for business, up to a maximum of $1,500 for a 300-square-foot space.

In this case, using the simplified method could make more sense since you’d get only $50 more in deductions by documenting actual expenses. You should also consider the time it will take you to gather receipts and records.

Among Turner’s clients, “the general rule is that they probably shouldn’t bother with the details if they have a small home office” of 100 square feet or less, she says.

The simplified method works well for single-room offices and small operations, while the actual-expenses method works better if the business makes up a large part of the home, says Tim Gagnon, a public accountant and director of Northeastern University’s online master of science in taxation program.

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Things to watch out for

If you plan on deducting actual expenses, keep detailed records of all the business expenses you think you’ll deduct, such as receipts for equipment purchases, electric bills, utility bills and repairs. If you’re ever audited by the IRS, you’ll be prepared to back up your claims.

But don’t let the fear of an audit keep you from taking the home office deduction, says Turner, who notes that in 35 years in business, she’s had only one customer undergo an audit.

If you’re a homeowner and you take the home office deduction using the actual-expenses method, it could cancel out your ability to avoid capital gains tax when selling your primary residence, says Craig Smalley, an accountant and financial advisor.

People who sell their primary residence after having lived in it for at least two of the five years before the sale generally don’t have to pay taxes on up to $250,000 in profit on the sale, or $500,000 if married filing jointly, according to IRS Publication 523.

If you use the actual-expenses method, you’re required to depreciate the value of your home. Depreciation refers to an income tax deduction that lets taxpayers recover the costs of property, due to wear and tear, deterioration or obsolescence of the property, according to the IRS. The depreciation you’re required to take in home office deductions is subject to capital gains tax when you sell your home, Smalley says.

» MORE: 7 reasons the IRS will audit you

For example, if you own your home, use 20% of it as a home office and deduct depreciation, 20% of your profit on the home’s sale is now subject to capital gains tax, Smalley says. However, if you use the simplified method, depreciation isn’t a factor and you won’t be subject to the tax, he says.

The rules on tax deductions for a home office can be hard to digest. Consult with a tax advisor or use the appropriate online tax software if you’re unsure about how to proceed.

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Steve Nicastro is a staff writer at NerdWallet, a personal finance website. Email: Twitter: @StevenNicastro.

Updated July 25, 2017.