Home Office Deductions 101
As tax season begins, you should look for all the deductions you can find. Don’t overlook the one for home office expenses. Many taxpayers are not clear about the rules and often shy away from this write-off because they think it’s too risky.
But if you have a legitimate home office and report your expenses properly, you have nothing to worry about.
In fact, the Internal Revenue Service is now trying to make it easier to compute the deduction. With the new Revenue Procedure 2013-13, beginning with returns filed for 2013, you have the option of using a new, simpler method for calculating direct and indirect home office expenses.
The new optional deduction is a flat $5 per square foot for up to 300 square 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 rule only changes how you calculate the deduction. It does not change the conditions you need to meet to qualify for it.
How do you know you can deduct home office expenses? To qualify, you must meet two conditions:
1. The office area must be used exclusively and regularly for business. It does not have to be a full room. The area can be part of a room, but it must meet these conditions. Exclusively means for business only – not for personal purposes like watching TV or sleeping. The use has to be part of your normal business conduct, not just occasional.
2. It must be either your principal place of business where you work most of the time, where you meet with customers, clients or patients or the place 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. This 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, N.Y. I also use an office in my home exclusively and regularly for my Certified Public Accountant and Certified Financial Planner 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 to qualify. Working at home 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 be used regularly for day care.
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, 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?
1. 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.
2. Indirect expenses. These are expenses that have mixed use, meaning they are shared with your living quarters. These include rent, mortgage interest, real estate taxes, utilities, homeowner’s insurance, security system, repairs, snow plowing, lawn care and garbage collection. They must be pro-rated between business and personal use based on the square footage of the office and the total square footage of the home.
Office equipment, such as printers and computers, depreciate every year – that is, their value or gradually drops. You can do the same with your home office. Depreciation is also a pro-rated, indirect expense and is based on the cost of the house plus improvements. Any mortgage interest and real estate taxes taken as home office expenses may not also be taken as itemized deductions.
3. Limits. If you are self-employed, you cannot deduct home office expenses if the deduction creates or increases a loss. You can, however, carry over the loss to be used next year. If you are an employee, the write-off 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 are not taxed on up to $250,000 of capital gains ($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 two out of the last five years. But if you used part of your house exclusively for business, you have a taxable gain equal to the total of all the depreciation taken since May 6, 1997.
For example, let’s say you sell your qualified residence at a gain of $50,000 and suppose all of the depreciation you took on the home office since that date in 1977 comes to $2,000. You 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 worthwhile? Playing fast and loose with the IRS is never a good idea. Don’t deduct the guest bedroom or the basement that is also a playroom. But if you clearly meet all the qualifications for a home office and you have the expenses documented, then by all means, the effort is worth it.
You get to deduct many expenses that are otherwise 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 you sell in the future, you will pay back the deduction you received for depreciation, but it is only a small part of what you deducted and the tax is at a lower rate.
You get to deduct many expenses that are otherwise 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 you sell in the future, the lower tax-free gains mentioned above are only a small part of what you deducted and they are taxed more favorably than ordinary income.
As for the new, simpler method mentioned in the beginning, it reduces the paperwork and recordkeeping requirements. But if you want to compare the two methods and use the older one, you still need those records.
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Charlie Benway CFP, CPA, is the principal of Main Street Financial LLC in Mount Kisco, N.Y. Charlie is a member of the American Institute of Certified Public Accountants, the New York State Society of CPAs, and the Financial Planning Association.
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