One of the biggest tax myths there is has to do with the home office deduction. People don’t take the deduction because they are afraid. And the fear is because of some myths. Let’s start with dispelling some common myths.
A home office deduction is NOT an IRS audit red flag, if you take the home office deduction properly
You can have another office somewhere and have a home office as well.
You don’t need to see clients, patients or customers in your home office.
You don’t need a separate entrance.
The Three Things You Need to Legally Take a Home Office Deduction
There are 3 things you need in order to take a home office deduction:
You need a business (or are a 1099 worker, independent contractor, etc),
The space needs to be exclusively used for the business, and
The space must be regularly used for the business.
An employee can’t take a home office deduction, even if his or her employer required them to work from home. But if the employee started a side business, then there is a deduction.
How to Calculate the Home Office Deduction
In the space that is exclusively and regularly used for business, calculate the square footage. Then calculate the entire square footage of your home.
Divide the business square footage by the total square footage to come up with the business percentage.
As an example, let’s say your house is 1200 square feet. Of that, 300 square feet is used for the business. The business square footage is 25%, calculated as 300/1200.
Now calculate all of your indirect home costs. These are costs are for the entire home and would include items such as real estate taxes, homeowner’s insurance, oil heat, gas and electric, water and sewer, alarm or security service, garbage disposal, general repairs and maintenance, landscaping, housekeeping and mortgage interest.
If you rent your home, the rent payment will also be an indirect home cost.
Apply the business use percentage to the indirect costs to determine the indirect expense portion of your home office. You may also have direct costs. These are costs directly related to your home office expense. It could be costs to repaint the room, costs to convert a bedroom closet to a bookcase, new flooring and the like.
The IRS Simplified Method
The IRS also has a simplified method. It is $5/square foot/year up to $1500 total for the year.
In most cases the indirect actual business use will be higher than that. Additionally, if the home office deduction is not allowed due to income limitations, you cannot carry forward the unused portion if you used the Simplified Method.
The other method using the business square footage is usually a better deal.
How to Report the Home Office Deduction for Sole Proprietorships, Partnerships and Corporations
If you have a Sole Proprietorship, you report your business on Schedule C of your form 1040 personal return. The Home Office calculation for Schedule C is done on Form 8829. The Home Office deduction on your Schedule C cannot create a loss for your business. If there is excess Home Office deduction, it will be suspended and rolled forward if you used the business percentage method. If you use the IRS’s “simplified” method, any of the deduction that would cause a loss is lost.
If you have a Partnership, the Home Office calculation is made separately and then the partner(s) are reimbursed for the actual expenses. Although partners aren’t actually employees, I recommend you follow the stricter requirements for employee/shareholders of a corporation.
The Home Office deduction is a little trickier for employee/shareholders. An employee cannot be reimbursed for a home office and neither can they take a deduction on their personal return.
That means the corporation cannot pay you a flat rental amount for use of the home office. Instead, set up an accountable expense reimbursement plan. “Accountable” refers to a specific type of employee benefit plan that is allowed by the IRS. Basically, you have a written plan with requirements that the employee keeps records and then submits an expense reimbursement report.
Corporations use “accountable” plans for tuition reimbursement, travel reimbursement, auto expense reimbursement and other like expenses. As an employee/shareholder, send in a monthly Employee Expense Report for the corporation. Request reimbursement for out of pocket business expenses such as postage, office supplies, parking, tolls, meals & entertainment, auto use (unless the company is taking the deduction directly) and, of course, the home office expenses.
What Happens to the Home Office When You Sell Your Home?
If you’ve lived in your home for 2 of the previous 5 years, you will likely have a capital gain exclusion when you sell your home for profit. (Note that if you first rented it out, this amount may be reduced).
One of the questions that comes up is what happens to the home office space you used. As long as the home office is attached to your personal residence (and not a separate building on the property), you will be able to use the capital gains exclusion for that space as well.
However, if you depreciated any part of the home office, the depreciation will need to be recaptured and it will be taxable.
The home office deduction can be a little tricky, but it doesn’t need to be. Use an experienced tax professional who is used to working with small businesses to make sure you’re getting all the deductions you’re entitled to.
Contact us to find out how you can work with our full service tax firm or join the coaching program.