Taking a home-office deduction might flag you for an Internal Revenue Service audit. But don’t let that stop you. If you play by the rules you can stand up to the IRS and save a bundle, especially if you use your home office for many years.
For starters Section 280A(c) of the tax code says you must devote the space exclusively to business on a regular basis. That doesn’t mean you need an entire room set aside for the purpose – just that you can’t use the area for other activities. For instance, if your home office doubles as a TV room, it’s usually not deductible. Two exceptions: if you run a daycare facility from your home or store inventory or product samples there, you don’t have to meet the “exclusive use” test.
Next, the IRS looks at the type of space and the role it plays in your business. Easiest to qualify are separate structures, such as studios, unattached garages or barns. You can deduct the expense of these areas if you use them in your trade or business.
For other parts of your home, the rules get more stringent. The office must either be your “principal place of business” or a space where you meet clients or customers. Your home qualifies as your principal place of business if you conduct administrative or management activities there, instead of running your company entirely from another place. The office doesn’t even have to be the only one, as long as you don’t conduct “substantial administrative or management activities” someplace else. (For more about working from home, see “How To Make Money Without A Job.”)
Employees who want to take the home office deduction have another hurdle. They must either use the space for the company’s convenience (rather than their own) or rent to their employer the area used for work. And since they claim the deduction as an unreimbursed job expense on Line 21 of Schedule A, it’s subject to what’s called the 2% rule: you tally up the expenses and subtract them from 2% of your adjusted-gross-income; you’re only allowed to deduct the excess – if any.
Assuming you satisfy the various tests, you can deduct both direct and indirect expenses of running a home office. Direct expenses, which are fully deductible, benefit only the business part of your home – painting the room that you use as an office, for example. Indirect expenses affect both the business and principal parts of the house or apartment. They include: utilities; insurance; general repairs; burglar alarms; and rent (if you don’t own your own home).
With indirect expenses, you’ll need to determine how much of your home is used exclusively for business or to store inventory or product samples. The easiest way to do this is to measure the total floor space and figure out, as a percentage of that area, how much of it your office occupies.
If you are a sole proprietor and do your own taxes using the TurboTax Home & Business software, it will step you through this process, as well as the choice you have starting for the 2013 tax year: whether to deduct a percentage of your actual expenses (which requires you to have receipts), or take a simplified deduction based only on the square footage of your home.
Don’t have good records or receipts to back up your expenses? You might prefer the latter, but unless you have a very small home office it is likely to result in a lower deduction; The new optional deduction is capped at $1,500 per year based on $5 a square foot for up to 300 square feet. Employees who opt for the simplified deduction must then apply the 2% rule (just as they would otherwise), which further whittles away (or completely eliminates) the deduction. (For more about unreimbursed employee expenses, see IRS Publication 529.)
Small business owners, who aren’t subject to the 2% rule, might like the idea that the simplified approach involves less tax-preparation paperwork. They can dispense with filing Form 8829, “Expenses for Business Use of Your Home,” and instead claim the home office deduction on Line 30 of Schedule C. But as a practical matter filing the extra form won’t make a difference if you use TurboTax, since based on the information you provide it will automatically generate Form 8829.
With either method, you cannot take a home office deduction if it would cause your business to operate at a loss. You can deduct home office expenses up to your net income (revenues minus other expenses) and carry over the rest to the following year.
Another thing you lose by taking the simplified deduction, whether you are an employee or self-employed, is the right to depreciate the portion of your home used in a trade or business. If you own your own home, this is another reason you might not want to take the simplified deduction.
Depreciation – a gradual reduction in the value of the house (but not the land) is also based on what portion of your home is used for business. Your total depreciation is that percentage times either the adjusted basis (the cost of the house plus capital improvements) when you install your home office or the fair market value at that time – whichever is less. Typically you would spread those deductions out over 39 years.
Whether you use the new option or the old method, you can still claim a deduction for mortgage interest, real estate taxes and casually losses on your home. The difference is that you would report the entire amount on Schedule A, instead of allocating it between personal and business use, as you would under the regular method of taking the home office deduction.
For more details on the home office deduction and the new option you can download IRS Publication 587.
Deborah L. Jacobs, a lawyer and journalist, is the author of Estate Planning Smarts: A Practical, User-Friendly, Action-Oriented Guide, now available in the third edition.
This article was written by Deborah L. Jacobs from Forbes and was legally licensed through the NewsCred publisher network.