Do you have a home office? What about an extra room or personal space in your household where you do a majority of your work from home? If so, it may be possible to receive a home office deduction. In order to do so, you must meet the requirements for qualification.
When operating a business out of your home, taxpayers can deduct specific expenses related solely to their trade or business. Originally, all employees could benefit from this deduction. Although, in 2017, the Tax Cuts and Jobs Act (TCJA) was signed and passed. This provision only allows for self-employed taxpayers, shareholders of corporations, or partners in partnerships to receive this deduction. For that reason, if you are self-employed, a shareholder, or a partner, you may qualify.
According to the IRS, your home office must be your “principal place of business” and it must meet their “exclusive and regular use” requirements. For example, if you have in-person meetings with patients, clients, or customers in your home in the normal course of business, you may qualify. If you have a home office and other office space elsewhere where you meet with clients, you will not qualify for the deduction as your home office is not your principal place of business. For the IRS’ exclusive and regular use requirements, the space in your home that you are using must be exclusive to your business. For example, if the home office is used for both business and creating jewelry, it does not qualify.
After determining that you qualify for this deduction, the next step is deciding whether to use your actual expenses, or the simplified method. Both of these methods are acceptable to the IRS and each have their own pros and cons.
Actual expenses, sometimes referred to as the regular method, requires the taxpayer to preserve strict records and keep receipts of all expenditures. These expenses may include mortgage interest, insurance, utilities, repairs, and depreciation. When using this method, deductions are based on the percentage of your home devoted to business use. For example, if your home is 1,500 square feet, and your office space is 150 square feet, 10% of your home is devoted to business use. Storage area in your home may also be included in this calculation, but only if it is exclusively used for your business purposes. Next, you must classify your expenses as direct, or indirect.
- Direct Expenses are expenses related to the business part of your home. For example, wall repairs in your home office would be a valid direct expense.
- Indirect Expenses are expenses related to the general upkeep of your home, such as the ones I mentioned above: mortgage interest, insurance, utilities, etc. These indirect expenses can be deducted based on the percentage of your home dedicated to business use. Using my example from earlier, if your home office is 10% of your home, you may be eligible to deduct 10% of these indirect expenses as a home office deduction.
The home office deduction cannot exceed your overall net income. If your deduction is not 100% utilized in the current tax year, it will be carried over into the next year.
Depreciation recapture occurs when you have taken depreciation on your home, and then you eventually sell the home. Although most of the gain may be excluded under the current home sale rules ($500,000 of gain excluded for a married couple, $250,000 for single) the amount you deducted as depreciation will be taxable. So, although you get a tax benefit when you take the home office, the depreciation portion may be taxable to you down the road.
Actual expenses have some calculation, allocation, and substantiation requirements that are complex and burdensome for small business owners. If this sounds relatable, the simplified method may be a better way of determining your home office deduction. An advantage while using this method is the ability to still deduct mortgage interest and real estate taxes for itemized deductions. With this method, your home will not be subject for depreciation recapture if you decide to sell.
For the simplified method, taxpayers would take the tax year’s prescribed rate multiplied to the allowable square footage of their home office. For the 2021 tax year, the IRS allows $5.00 per square foot of the home office up to 300 square feet. Using our example from earlier, if your office is 150 square feet, you would multiply 150 by $5.00, arriving at a total deduction of $750. An important thing to note is that you must choose between the simplified method or the regular method, you cannot utilize both at once. It is also important to note that the deduction from the simplified method cannot exceed the net income of the business. The simplified method does not allow for the carryover of any losses that are not utilized, meaning one cannot create a business loss.
Tax season is right around the corner. If you need a trusted tax advisor, gather your tax documents and create an appointment with ADKF, P.C. today and we can help you determine if you qualify for a home office deduction.