If you are a sole proprietor or a single-member LLC and use a portion of your home for business, then you could be eligible for a home office tax deduction that could significantly lower your tax bill. In this article, we will provide you with the information you need to claim the home office tax deduction, including:
- Do you Qualify for the Home Office Tax Deduction?
- Types of Expenses You Can Deduct
- How to Calculate the Home Office Deduction – 2 Methods
- What Tax Form to Use
- What Documents You Should Keep on File
Do You Qualify for the Home Office Tax Deduction?
In order to qualify for the home office tax deduction, there are two tests that you must meet:
1. Regular and Exclusive Use Test
To meet this test, you must regularly use part of your home exclusively for conducting business. For example, if you have an extra room that you use to run your business and that room is not used for any other purpose, then you have met the regular and exclusive use test. A specific area in your home that is not a separate room but is used exclusively for conducting business will also qualify.
If you have a seasonal business that you operate for just part of the year, you are eligible to take this deduction for the portion of the year that you use the space for your business. For example, if you make holiday gift baskets from September thru December, then you are eligible to deduct the space used for this business for the 4 months that you run your business.
As with most IRS rules, there are a couple of exceptions to the regular and exclusive use test. You do not have to meet the exclusive use test if either of the following apply:
- Part of your home is used to store inventory or product samples
- You use part of your home as a daycare facility
2. Principal Place of Business Test
To meet the requirements of this test, you must prove that you use your home as your principal place of business. You can have more than one place where you conduct business, but in order to be eligible for the home office deduction, you need to conduct the majority of your business tasks like meeting clients and conducting administrative tasks at your home office. In addition, you cannot have another location where you conduct substantial administrative or management tasks. Here are a few examples of what the IRS considers to be administrative or management activities:
- Invoicing customers
- Scheduling appointments
Below is an example from IRS Publication 587 of a self-employed plumber who meets the requirements of the home office deduction:
Example – John is a self-employed plumber. Most of John’s time is spent at customers’ homes and offices installing and repairing plumbing. He has a small office in his home that he uses exclusively and regularly for the administrative or management activities of his business, such as phoning customers, ordering supplies, and keeping his books.
John writes up estimates and records work completed at his customers’ premises. He does not conduct any substantial administrative or management activities at any fixed location other than his home office. John does not do his own billing. He uses a local bookkeeping service to bill his customers.
John’s home office qualifies as his principal place of business for deducting expenses for its use. He uses the home office for the administrative or managerial activities of his plumbing business, and he has no other fixed location where he conducts these administrative or managerial activities. His choice to have his billing done by another company does not disqualify his home office from being his principal place of business.
He meets all the qualifications, including principal place of business, so he can deduct expenses (subject to certain limitations, explained later) for the business use of his home.
Refer to IRS Publication 587 Business Use of Home to see more examples like this.
Type of Expenses You can Deduct
Here are some examples of the types of home office expenses you can deduct:
- Repairs and maintenance to the area used for business
- Real estate taxes
- Deductible mortgage interest
Depending on how you calculate your home office deduction, you may have to categorize certain business expenses. Below, you will find a quick reference chart that you can use to determine what type of an expense you have and whether or not it qualifies for the home office tax deduction.
Types of Business Expenses That Are Eligible for Home Office Tax Deduction
|Direct||Expenses only for the business part of your home (e.g. repairs or improvements made to the space that you use for your office).||100% Deductible|
|Indirect||Expenses for keeping up your entire home (e.g. insurance, utilities, general repairs).||Deductible based on the percentage of your home used for business. For example, if my home office space is 10% of the total square feet of my home then I can deduct up to a maximum of 10% of indirect expenses.|
|Unrelated||Expenses for the areas of your home that are not used for business (e.g. lawn care, pool service, etc).||Not deductible|
How to Calculate the Home Office Tax Deduction – 2 Methods
One of the reasons why many business owners did not bother to take the home office tax deduction in the past is because it required that you compute the actual expenses of your home office which made it very complicated to calculate. Beginning with the 2013 tax year, the IRS offered a new simpler method to calculate the home office tax deduction.
Simplified Method Calculation
To calculate the home office deduction using the simplified method, you need the following information:
- The square footage of the area of your home that you use for business, not to exceed 300 square feet. For tax purposes, this is called the allowable area.
- The gross annual income of your business. You should be able to get this information from your profit and loss statement for the tax year.
- Your total annual business expenses (not related to the use of your home). In other words all expenses related to the business and not related to your home should be counted (e.g. you would not count utilities and rent). You should be able to get your total expenses from your profit and loss statement for the tax year.
Once you have computed the allowable area, your gross income, and total expenses, follow the steps below to calculate your home office deduction:
1. Multiply the allowable area (calculated in item #1 above) by $5. (if you are a Daycare, see IRS Publication 587 for special rules that apply)
Example: For my home office, I have an allowable area of 250 square feet. I will multiply 250 by $5 as indicated below:
250 X $5 = $1250
2. Take your gross business income, and subtract your total business expenses. If total expenses exceed income, then you are not eligible to take the home office deduction.
Example: According to my profit & loss statement, my gross income is $10,000, and my total expenses are $4000. Calculate the difference between these two figures as indicated below:
$10,000 – $4,000 = $6,000
3. If the difference between your income and expenses is a positive number (like we have in this example) then proceed to step 4. However, if your total expenses exceed your gross income (resulting in a negative number) then you do not qualify for a home office tax deduction.
4. Take the smaller of the results between items #1 or #2, and this is the amount you are allowed to deduct for your home office expenses.
Example: My result for item #1 was $1250 and for item #2 it was $6000. Therefore, my home office deduction is $1250, which is the lesser of the two.
Regular Method Calculation
If you do not meet the requirements to take the home office deduction using the Simplified Method because your expenses exceed your income, then you can use the Standard or Regular Method to see if you qualify to take the deduction. While the regular method requires a bit more work to calculate, it could give you a larger deduction because it is based on actual expenses as oppose to just a straight formula based on the square footage of the space used multiplied by $5.
Example: Under the Simplified method, a business owner who lives in New York City with a 200 square foot home office and another business owner who lives in Boise, ID with a 200 square foot home office would both end up with the exact same deduction, assuming that their gross income is more than $1000:
200 sq. feet times $5 = $1000
Since it is a lot more expensive to live in NYC, it generally might work in the NY taxpayer’s favor to use the Regular Method which is based on actual expenses as opposed to the Simplified Method.
Follow the steps below to calculate your home office tax deduction based on the Regular Method:
1. Calculate the percentage of your home that is used exclusively for business.
Example: If you have a 2000 square foot home and your home office is 200 square feet, then the percentage of your home office space is calculated as follows:
200/2000 = 10%
2. Categorize all expenses to determine deductibility.
The IRS has categorized expenses into 3 types: Direct, Indirect, or Unrelated. Reference our table above to see what types of expenses fall into each category.
Similar to the simplified method, if your total gross income exceeds your total expenses then you can deduct all of your direct expenses and indirect business expenses related to the use of your home office under the regular method. However, if your total business expenses exceed the gross income from your business, then your deduction for certain expenses for the business use of your home will be limited under the regular method. To learn more about these limitations, refer to IRS Publication 587.
What Tax Form to Use
Since the home office tax deduction is only available to self-employed businesses and single-member LLCs that file a Schedule C, you would complete Form 8829. Then, follow the instructions on the form to transfer your home office deduction to the appropriate line on your Schedule C.
Documents You Should Keep on File
You should keep on file any information that you used to calculate the home office deduction. This will be of use in case you are audited. Save cancelled checks, copies of bills, and receipts. You should also have documented the square footage of the part of your home that you use for business.
Keep these records on file for at least 3 years after the date that you filed your tax return. If possible, scan these documents to your computer for safekeeping.
When tracking expenses related to your home office deduction, remember to separate anything business related from your personal expenses. For example, your monthly cable television expense should be separated from the monthly charge for internet access since internet access can be business related, while cable charges are generally not. Same goes for family members that share a cell phone plan with you. Michael Ly, CEO of Reconciled It
If you do your own taxes, I suggest that you use a tax software like TurboTax. After you enter the information about your home office, TurboTax will automatically calculate your deductions for you! If you have a tax professional who prepares your tax return, let them know that you use a portion of your home for business. They will do all of the required calculations to see what kind of deduction you qualify for.
Be sure to check out our Top 15 Business Tax Saving Tips article for other great tax deductions that you may qualify for. We would love to hear from you. Leave a comment below to let us know what your favorite tax savings tip is and why.