For some, one of the positives arising from the pandemic is the perk of working from home. Working from home can certainly provide you with personal benefits, such as a flexible schedule and more family time. But increasing numbers of people are discovering the tax advantages as well. It’s no secret that you generally can’t deduct certain personal expenses (i.e., homeowners’ insurance, utilities, and home repairs) on your federal income tax return. But if you’re using part of your home as a home office, you may be able to write off part of these expenses.
The general rule is this: Those who are self-employed and working out of their homes may be eligible for the tax break. People who work remotely but get a W-2 tax form from their employer don’t qualify. To qualify for the home office deduction, you must first understand the IRS requirements.
What is a home office?
A home office is a room in your home, a portion of a room in your home, or a separate building next to your home (such as a converted garage or barn) that you use exclusively and regularly to conduct business activities.
This definition is important, because you may be able to deduct part of your housing expenses (such as rent, utilities, and insurance) on your federal income tax return if you have a home office. This deduction (or group of deductions) is known as a home office deduction. To take the deduction, you’ll need to file Form 8829 with the IRS. To even consider the home office deduction, though, your at-home business activities must involve a trade or business — a hobby won’t do.
Now let’s consider the IRS requirements. To qualify for a home office deduction, you must meet two threshold tests — the place of business test, and the regular and exclusive use test.
Place of Business Test
To pass this test, you must show that you use part of your home as:
In some cases, you can also meet the principal place of business requirement if you conduct substantial administrative and management tasks for your outside business at home and have no other fixed location where you conduct these activities. These tasks might include billing customers, keeping books and records, ordering supplies, setting up appointments, or writing reports. For example, assume you’re a doctor at a local HMO who’s been given examination space but no office space. You use a room in your home regularly and exclusively to correspond with insurance companies, bill patients, and read medical journals. You have no other fixed location for conducting these types of activities. In such a case, your space would likely pass the place of business test for a home office deduction.
What if your home office is in a separate structure next to your home, like a shed or garage? In that case, it needn’t be your principal place of business. However, you must use that office regularly and exclusively in connection with your trade or business. Be sure you use this structure only for business purposes — you can’t store your car there.
Exclusive Use Test
In general, you must also pass the regular and exclusive use test before you can take a home office deduction (exceptions apply for taxpayers who run day-care facilities from home and for sellers who use part of their homes for storing inventory). As you might expect, this test requires you to show that you exclusively use a portion of your home for business purposes on a regular basis.
For example, assume you set aside one room in your home as your home office. You also use this room as a playroom for your children. Here, you wouldn’t meet the exclusive use test. Now assume that you use one room in your home exclusively for your side business of selling insurance. You engage in this business only occasionally. Because you don’t use the office on a regular basis, you still won’t qualify for the home office deduction.
What can you deduct if you qualify?
You can deduct both your direct and indirect expenses regarding your home office. Direct expenses are costs that apply only to your home office. You can deduct these costs in full against your business income. Some examples include the cost of a business telephone line and the cost of painting your home office. However, no deduction is allowed for basic local telephone charges on the first line in your home, even if that line is used for the home office.
Indirect expenses are costs that benefit your entire home. You can deduct only the business portion of your indirect expenses. Some examples of indirect costs include rent, deductible mortgage interest, real estate taxes, and homeowners’ insurance. The business percentage of your home is determined by dividing the area exclusively used for business by the total area of the home. For example, assume your home is 2,000 square feet and your home office is 200 square feet. Your business percentage is 10 percent (200 divided by 2,000). In such a case, if you rent your home, you can deduct 10 percent of your rent as part of your home office deduction.
Note: For tax years beginning on or after January 1, 2013, you’re able to use an optional simplified method of calculating your home office deduction rather than the simplified method described above. We will not cover this optional method in this post.
Even if you don’t qualify for the home office deduction and are unable to deduct home-related expenses (i.e., homeowners’ insurance), you can still take a deduction for your regular business expenses, such as the purchase of file cabinets, business equipment, and supplies.
If the gross income from your business (the one associated with the home office) equals or exceeds your regular business expenses (including depreciation), all expenses for the business use of your home can be deducted. But if your gross income is less than your total business expenses, certain expense deductions for the business use of your home are limited. The deduction isn’t lost forever, though. It’s simply carried forward to the next year.
Historically, the IRS has closely scrutinized home office deductions. Here are some steps you can take to substantiate the existence of your home office:
Having a home office can be a factor when you sell your home.
Unless you’re careful, deductions today can cost you money when you sell your home. Homeowners who meet all requirements can generally exclude from federal income tax up to $250,000 of capital gain (up to $500,000 if you’re married and file a joint return) when a principal residence is sold. You may end up paying some taxes, though, if you have a home office. That’s because when you sell your principal residence, an amount of capital gain equal to certain depreciation deductions you were entitled to (as a result of having your home office) won’t qualify for the exclusion. Specifically, the exclusion won’t cover an amount equal to depreciation deductions attributable to the business use of your home after May 6, 1997.
Note: In addition, where the business portion of the home is separate from the dwelling unit (i.e., an office in a converted detached garage) any capital gain on the sale of the house has to be apportioned; only the part of the gain allocable to the residential portion is eligible for exclusion.
For example, assume a self-employed accountant bought a home in 1998 and sells the home several years later at a $20,000 gain. Although the house was always used as his principal residence, the accountant used one room within the house as his business office. Over the years, the accountant claimed $2,000 of depreciation deductions for his office. Under IRS regulations, $18,000 of the capital gain will be tax free. Only the $2,000 of the gain equal to the depreciation deductions will be taxable.
If the accountant’s office had been located in a converted detached garage on his property, he would have to treat the sale as two separate transactions and pay tax on any gain allocable to the converted garage.
Because this area is complex, you should consult a tax professional. Also, you might want to read IRS Publication 587, Business Use of Your Home.1
There are many tax strategies available for business owners, but it requires proper planning throughout the year. If you’d like to learn more about tax planning strategies unique to your business, feel free to Talk With Us!
Prepared by Broadridge Advisor Solutions. Edited by BFSG. Copyright 2022.
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