More people are working from home than ever before! Generally, as a taxpayer, you are always looking for ways to maximize your deductions to reduce your tax liability. If you qualify, the home office deduction can result in significant tax savings because it allows you to deduct a portion of certain expenses related to your home.
However, certain conditions must be met to qualify for the home office deduction, and taking this deduction might not always be advisable.
Let’s look at five things you should consider carefully before taking the deduction:
- Who can claim the deduction?
As of 2018, W-2 employees can no longer claim the home office deduction as part of unreimbursed job expenses even if they work from home. Before the Tax Cuts and Jobs Act of 2017, as a W-2 employee, you could take the deduction as part of unreimbursed business expenses if you itemized deductions. The home office deduction is now available to independent contractors and self-employed individuals. The deduction is available regardless of whether you own or rent your home.
- What constitutes a home office?
The IRS definition of a “home” is broad and includes a house, apartment, condominium, mobile home, boat, or similar property. It can also include unattached structures on your property, such as a detached garage, studio, barn, or greenhouse. However, it does NOT include property that is used exclusively as a hotel, motel, inn, or similar business.
There are two criteria to be satisfied to qualify your home as a “home office”:
- The home must be your principal place of business.
- A defined portion of the home must be used exclusively to conduct your business regularly (this is known as the “regular and exclusive use” rule).
To qualify as your principal place of business, you must prove that you spend most of your working time there and that most of your business income is derived from the activities you conduct there. Generally, your space will qualify if you have no other fixed location where you conduct substantial managerial or administrative functions for your trade or business.
There are a couple of specific exceptions to the regular and exclusive use rule:
- When you operate a daycare center in your home
- When you store inventory or products for sale in your business in your home.
If neither of these exceptions applies to satisfy the regular and exclusive use requirement, the space, while it does not need to be partitioned off, cannot be used for any other purpose than the conduct of activities related to your business.
- What types of expenses can be included in calculating the deduction?
Both direct and indirect expenses may be included in calculating the home office deduction. Direct expenses are those that specifically relate to the designated space, such as repairs, painting, or remodeling to make the space suitable for use as an office will be fully deductible. A portion of indirect expenses will also be deducted. The types of indirect expenses (which relate to the home as a whole) that can be included in calculating the home office deduction include rent or mortgage interest, property taxes, insurance, utilities, and depreciation. In addition, any excess mortgage interest and property taxes may be deductible as itemized deductions.
- How do you claim the deduction?
The home office deduction will be calculated on Form 8829 and included on Schedule C or Schedule F on your individual tax return if you are self-employed.
There are two methods for determining the amount that can be claimed as the home office deduction: the actual expense method and the simplified method. Under the actual expense method, the deductible proportion of indirect expenses is calculated based on the proportion of the square footage of the dedicated space to the total square footage of the home and then added to total direct expenses. The IRS introduced the simplified option in 2013. Under this method, $5 per square foot of dedicated space, not to exceed $1,500 in total (based on 300 sf) for all home office spaces (even if you have more than one dedicated home office space).
The home office deduction cannot create or add to a loss. Any excess amount is treated differently depending on which method is used to calculate the deduction. If the actual expense method is used and the calculated amount would create or add to a loss, the excess amount can be carried over to future years, whereas if the simplified method is used, any excess cannot be carried over. In addition, if you change from the actual expense method to the simplified method, any carryovers calculated while using the actual expense method will be lost.
- What are the pros and cons of claiming the deduction?
The most obvious “pro” is that the home office deduction may reduce your taxable income and thus your tax liability. Costs that might not otherwise be deductible against ordinary income or as itemized deductions can be included in the home office deduction. However, a related “con” is that it cannot create or add to a loss, so your deduction may be limited, or you might not be able to take it. Some additional “cons” include the potential for increased time for recordkeeping and increased costs for compliance.
Finally, a major “con” is that if you sell your house after you have claimed the home office deduction as calculated under the actual expense method, the capital gains exclusion on the sale of a personal residence will be reduced.
While the tax savings from a home office deduction may be more significant than the costs of any future tax that the IRS recaptures when you sell your home, you should make sure that you fully understand the criteria for claiming the deduction, the methods of calculation, and the impact of the choice of method on carryovers and potential future tax liability.