Tristen Bennett
The IRS may inspect your home office space if you claim a home office deduction on your tax return. This is a legitimate deduction that can save you money on your home expenses, including rent, utilities, repairs, property taxes, and more. However, it is important to be aware of the requirements and keep clean records to avoid triggering an audit. The IRS has two basic requirements for the deduction: the space must have “regular and exclusive use” and be your “principal place of business.” This means that you must use the designated area in your home only for conducting business and cannot use it for any personal activities or storage. Keeping detailed records and consulting with a tax advisor are recommended to ensure compliance with IRS rules and minimize the risk of an audit.
| Characteristics | Values |
|---|---|
| IRS inspection of home office space | Rare but possible |
| Requirements to avoid IRS inspection | Regular and exclusive use for business, no personal items, detailed record-keeping |
| Benefits of home office deduction | Expense reduction for office space, reduced tax burden, reduced self-employment taxes |
| Methods for determining deduction amount | Simplified Method, Regular Method |
| Factors influencing audit risk | Profession, amount of space claimed, changes in tax law, IRS fraud prevention system |
What You'll Learn
The IRS's regular and exclusive use test
The exclusive use rule does not mean that you are forbidden from making a personal phone call from the office or that you have to rush outside whenever a family member needs a moment of your time. However, you must not let your children use the office to do their homework, for example, as this would violate the exclusive-use requirement.
The regular use test is applied to the facts and circumstances of each case the IRS challenges. There is no specific definition of what constitutes regular use, but if you work in the home office a few hours each day, for example, you might pass.
If you are an employee of another company but also have your own part-time business based in your home, you can pass the home office test even if you spend much more time at the office where you work as an employee.
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The Simplified Method for calculating deductions
The Simplified Method for determining the home office deduction is an easier way to calculate the expenses you can deduct for the use of your home as a business. This method is an alternative to the standard method, which has many calculation and substantiation requirements that can be complex and burdensome for small business owners. The simplified method is intended to reduce that difficulty.
The simplified method was introduced in 2013 and can be used for taxable years beginning on or after January 1, 2013. This method allows taxpayers to deduct a standard rate per square foot of their home office space, with a maximum of 300 square feet or $1,500 per year. The standard rate is currently set at $5 per square foot.
To use the simplified method, you must meet certain requirements. The space must be your "principal place of business" and must be used "regularly and exclusively" for business purposes. This means that you must use the designated area in your home only for "conducting business" and cannot use it for any personal activities or family use. Additionally, your home office should be used regularly, not just occasionally, for business purposes.
It is important to note that the simplified method does not change the criteria for who may apply for home office deductions. It only simplifies the calculation and record-keeping requirements. When using this method, you cannot deduct any actual expenses related to the business, such as repairs, mortgage interest, or utilities. However, you can still claim some home-related personal deductions, such as mortgage interest and real estate taxes, but you will have to forgo the standard deduction.
The simplified method offers a straightforward way to calculate your home office deduction and reduces the burden of record-keeping. However, it may not always result in the highest possible deduction. The regular method, which is based on the percentage of your home used for business and your actual expenses, may provide a larger deduction, especially if you have a large home office or significant expenses.
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The Regular Method for calculating deductions
Next, you need to find out the total square footage of your home. Let's say, for this example, your home has an area of 1,600 square feet.
Now, divide the area of your office by the area of your house. In this case, 225 divided by 1,600 equals 0.14 or 14%. This percentage represents the portion of your home expenses that can be allocated towards the home office deduction.
After determining the percentage of household expenses that can be written off, list all the expenses that pertain to your entire home for the year, such as mortgage interest, real estate taxes, insurance, utilities, and depreciation. These are considered "Indirect expenses" and go on the relevant section of Form 8829.
Expenses incurred solely for the benefit of the office space are then listed separately under the "Direct expenses" section of the form. Add up the indirect expenses and multiply that total by the percentage derived earlier (in this case, 14%). Finally, add that figure to the total of the direct expenses, and that is the amount you can deduct using the Regular Method.
It is important to note that you may not deduct business expenses in excess of the gross income limitation. Additionally, under the Regular Method, you may be able to carry forward some business expenses to the next year, subject to the gross income limitation for that year.
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The principal place of business requirement
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.
The Place of Business Test
The place of business test is somewhat flexible. To pass this test, you must show that you use part of your home as:
- The principal place of business for your trade or business
- A place where you regularly meet with clients, customers, or patients
- A place where you conduct substantial administrative and management tasks for your outside business and have no other fixed location where you conduct these activities
The Regular and Exclusive Use Test
In general, you must also pass the regular and exclusive use test before you can take a home office deduction. This test requires you to show that you exclusively use a portion of your home for business purposes on a regular basis.
Exceptions
There are some exceptions to the regular and exclusive use test. For example, taxpayers who run daycare facilities from home and sellers who use part of their homes for storing inventory may still qualify for the home office deduction even if they don't meet this test.
Telecommuters
If you telecommute or are an employee who works at home, you may also qualify for the home office deduction, but your home office must be for the convenience of your employer. In other words, your employer must ask you to work from home, and the arrangement must serve their business needs.
Direct and Indirect Expenses
If you qualify for the deduction, you can deduct both your direct and indirect expenses related to your home office. Direct expenses are costs that apply only to your home office, such as the cost of a business telephone line or the cost of painting your home office. Indirect expenses are costs that benefit your entire home, such as 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.
Limitations on Deductions
If the gross income from your business is less than your total business expenses, certain expense deductions for the business use of your home are limited. However, the deduction isn't lost; it's simply carried forward to the next year.
IRS Scrutiny
Historically, the IRS has closely scrutinized home office deductions. To substantiate the existence of your home office, you can take steps such as using your home address on your business cards and advertisements, installing a separate telephone line for your business, instructing clients or customers to visit your home office and keeping a log of those visits, logging the dates and hours spent working in your home office, and having business mail sent to your home.
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The IRS's fraud prevention system
The IRS uses a multi-pronged approach to combat tax fraud. The IRS Criminal Investigation (IRS-CI) division investigates and assists with the prosecution of various types of fraudulent activity, including money laundering, the misuse of COVID-relief funds, and phony cryptocurrency investment schemes.
The IRS also has a dedicated Office of Fraud Enforcement (OFE) that works to improve fraud detection and address areas of high-risk non-compliance. The OFE identifies and pursues potential fraud, strengthens internal and external partnerships, and provides specialised training to IRS employees to help them recognise signs of fraud.
Additionally, the IRS uses a computer system known as the Discriminant Inventory Function (DIF) to identify tax returns that deviate significantly from the averages in their profession, which may indicate fraud.
The IRS also provides educational materials to help taxpayers recognise and avoid abusive tax schemes and offers ways to report suspected tax fraud, including:
- Form 3949-A, Information Referral, for reporting suspected tax law violations
- Form 211, Application for Award for Original Information, to claim an award for reporting tax fraud
- Identity Theft Central, for reporting suspected identity theft
- Form 14242, to report abusive tax promotion or avoidance schemes
- Form 14157, to report fraudulent activity by a tax return preparer or company
- Form 13909, to report misconduct or wrongdoing by an exempt organisation or employee plan
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Frequently asked questions
The home office deduction is a tax write-off that allows self-employed workers and independent contractors to deduct a portion of their home office expenses from their taxes.
The IRS lists two basic requirements to qualify for the deduction: the space must have regular and exclusive use and be your principal place of business.
With the home office deduction, you may be able to deduct expenses such as mortgage interest, insurance, utilities, repairs, and depreciation for the area of your home used for business.
There are two methods to calculate the amount of your deduction: the Simplified Method and the Regular Method. The Simplified Method allows you to deduct up to $5 per square foot of the space used for business, with a maximum of 300 square feet or $1,500. The Regular Method involves calculating the percentage of your home used for business and deducting a portion of your expenses based on that percentage.
Claiming the home office deduction alone will not trigger an IRS audit. However, depending on your tax situation, it could be a red flag. For example, if it is unusual for someone in your profession to claim a home office, or if you claim too much space for your home office, you may be more likely to be audited.
