Depreciating Home Office: Tax Strategy

how to depreciate a home office for tax purposes

Depreciating Your Home Office

Depreciation is a complex but important aspect of tax filing for those who work from home. It can be a powerful tool for reducing your tax bill, but it's also a little-understood area of tax law.

In simple terms, depreciation is an accounting and tax calculation that puts a dollar value on the normal wear and tear of assets you use in your business. For those who work from home, this means you can deduct a percentage of your home's value as a business expense.

There are two methods for calculating depreciation: the Simplified Method and the Actual Expenses Method. The Simplified Method allows you to multiply the square footage of your home office by a prescribed rate of $5 per square foot, up to a maximum of $1,500 for a 300-square-foot space. The Actual Expenses Method is more complicated and involves calculating the proportion of your home's overall space devoted to your office and then determining what percentage of your overall home expenses went towards your home office. This method requires a lot more math and record-keeping but may result in larger deductions.

It's important to note that depreciation deductions on your home office may increase the amount of profit on a home sale that's subject to taxes. Consult a tax professional to understand how depreciation deductions will affect your tax liability when you sell your home.

Characteristics Values
Who can claim the home office deduction? Self-employed people who use part of their home for business activities.
Who cannot claim the home office deduction? Employees
Where can the home office deduction be claimed? Schedule C of Form 1040 (annual tax return)
Are there any exceptions to the exclusive use rule? Daycare services, storage of inventory or product samples
What are the two methods to calculate the home office deduction? Simplified method, Actual expenses method
What is the simplified method? $5 per square foot for up to 300 square feet of space, with a maximum deduction of $1,500
What is the actual expenses method? Measuring actual expenditures against overall residence expenses
What is depreciation? An accounting and tax calculation that puts a dollar value on the normal wear and tear of assets
What is the basis for depreciation? The cost of the home generally includes the price paid to the seller, closing costs, and settlement fees

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Depreciation Calculation

Depreciation is a way to reduce your business income, thereby saving on income taxes and self-employment taxes. It is an accounting and tax calculation that puts a dollar value on the normal wear and tear of assets used in your business.

The first step in calculating depreciation is to determine the business percentage. This is done by dividing the area of your home office (in square feet) by the total area of your home (in square feet). This business percentage will then be used to calculate your depreciation deduction.

Next, you need to gather some information to calculate the adjusted basis of your home:

  • The total cost of your house when you bought it
  • The value of the land when you bought your home
  • The fair market value (FMV) of your home when you started using a home office
  • The full cost of any whole-home improvements you've made
  • Any casualty losses related to your home that decreased its value

The formula for calculating the adjusted basis is:

> Adjusted basis = purchase price of home – land value + improvements – casualty losses

Once you have the adjusted basis, compare it to the FMV of your home (excluding land). Whichever number is lower will be used in the next step.

According to the IRS, your home office is considered "nonresidential rental property" that can be depreciated over 39 years using the straight-line method. To calculate the annual depreciation, divide the lower number (adjusted basis or FMV) by 39.

However, in the first and last years of taking the depreciation expense, you need to use the IRS chart based on the month you started using the home office. For example, if you started in June, use the percentage for month 6 on the chart.

Finally, multiply the current year's depreciation by the business percentage you calculated earlier to get your depreciation deduction for the year.

Here's an example:

Let's say David started using a home office in May 2022. He bought his house for $300,000 and made improvements worth $20,000. The area of his office is 120 square feet, and his whole home is 1,200 square feet.

First, calculate the business percentage:

> % use of home for office = 120 x 100/1200 = 10%

Next, calculate the adjusted basis:

> Adjusted basis = $300,000 - $30,000 + $20,000 = $270,000

Since David started in May, use the depreciation factor for month 5 from the IRS chart, which is 1.605%.

Calculate the total deprecation for the house for 2022:

> $270,000 x 1.605% = $4,333.50

Now, multiply the total depreciation by the business percentage:

> $4,333.50 x 10% = $433.35

So, David's depreciation deduction for his home office in 2022 is $433.35.

In subsequent years, the total depreciation would be $8,974.36 ($270,000/39 years), and the depreciation deduction would be $897.44 ($8,974.36 x 10%).

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Home Office Requirements

To qualify for the home office tax deduction, your home office must meet the following requirements:

Exclusive and Regular Use

You must use a portion of your home exclusively and regularly for your business. This includes a house, apartment, condominium, mobile home, boat, or similar structure, as well as unattached studios, barns, or garages. The space must be used solely for business purposes and cannot be used for personal activities. However, there are exceptions for daycare and storage facilities.

Principal Place of Business

Your home office must be either the principal location of your business or a place where you regularly meet with customers or clients. If your home office is in a separate, unattached structure, you only need to meet the exclusive and regular use requirements.

Qualifying as a Business

Your business endeavors must be substantial in terms of time and effort invested and income generated. Profit alone may not be sufficient to qualify. Activities such as managing personal investments or taking care of children do not qualify as a business.

Calculating the Deduction

You can calculate the home office tax deduction based on either the percentage of your home used for business or a simplified square footage calculation. The simplified method uses a prescribed rate of $5 per square foot, with a maximum of 300 square feet.

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Expense Classification

When it comes to expense classification for tax deductions on a home office, there are two methods: the simplified method and the actual expenses method.

Simplified Method

The simplified method does not involve deducting actual expenses. Instead, the square footage of your home office space is multiplied by a prescribed rate. The rate is $5 per square foot for up to 300 square feet of space, with a maximum deduction of $1,500. This method is suitable for single-room offices and small operations.

Actual Expenses Method

The actual expenses method is more complex and involves measuring actual expenditures against overall residence expenses. This method allows you to deduct direct and indirect expenses. Direct expenses, such as painting or repairs done solely in the home office, can be deducted in full. Indirect expenses, including mortgage interest, insurance, home utilities, real estate taxes, and general home repairs, are deductible based on the percentage of your home used for business. This method is more suitable when the business makes up a large part of the home.

Other Considerations

If you are deducting actual expenses, it is important to keep detailed records of all business expenses, such as receipts for equipment purchases, utility bills, and repairs. Additionally, taking the home office deduction using the actual expenses method may impact your ability to avoid capital gains tax on home sales.

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Mortgage Interest

You can also deduct mortgage interest on a second home, providing it is listed as collateral for that mortgage. If you rent out your second home, you must live there for more than 14 days or more than 10% of the days you rent it, whichever is longer.

You can also deduct mortgage interest on a home equity loan, providing you use the money to buy, build, or substantially improve your home.

Homeowners insurance, mortgage insurance premiums, other closing costs, moving expenses, money forfeited while home-buying, and interest on a reverse mortgage do not qualify for the mortgage interest deduction.

How to Claim the Mortgage Interest Deduction

You will need to itemize your deductions to claim the mortgage interest deduction. Since mortgage interest is an itemized deduction, you'll use Schedule A (Form 1040), an itemized tax form, and the standard 1040 form.

You will need a Form 1098 from your mortgage lender or mortgage servicer, which details how much you paid in mortgage interest and points during the past year. Your lender or mortgage servicer will send the form at the beginning of the year your taxes are due.

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Depreciation Basis

Depreciation is an accounting and tax calculation that puts a dollar value on the normal wear and tear of assets that you use in your business. It is the most confusing part of the full home office deduction, but it can substantially minimise your current tax bill.

You can only take a depreciation deduction if you own your home. The business asset in this case is your home – or at least the portion that you’re using for your home office. Each year, you get to deduct a percentage of its value as a business expense – as long as you meet all the rules for the home office expense deduction.

The first time you work out your depreciation, you’ll need to gather some information:

  • The total cost of your house when you bought it
  • The value of the land when you bought your home
  • The fair market value (FMV) of your home at the time you started using a home office
  • The full cost of any whole-home improvements you’ve made
  • Any casualty losses (e.g. flood damage) you’ve sustained related to your home that decreased its value

First, you need to calculate the adjusted basis of your home. Here’s how to get that:

Adjusted basis = purchase price of home – land value + improvements – casualty losses

Next, compare the adjusted basis you just calculated to the FMV of your home (not including land). Whichever number is less is the one you’ll use going forward, and you never have to figure it out again.

Home improvements include only things that increase the value of your house, not just regular repairs and maintenance. Examples include replacing your roof, rewiring your electrical system, or updating the plumbing.

Now that you know your basis for depreciation, you can figure out the depreciation expense. This part is pretty straightforward. According to the IRS, your home office counts as “nonresidential rental property” that gets depreciated over 39 years using the straight-line method. Basically, just divide the lesser of your adjusted basis or FMV by 39 and that’s the annual depreciation.

The only times the number will be different is the first year and last year you’re taking depreciation expense for your home office. For the first year, you have to use the IRS chart based on the month you started using the home office. Choose the percentage that’s listed next to the month you started using the home office this year. For example, if you started using it in June your percentage would be 1.391% for month 6.

Now that you’ve figured out the current year depreciation, you have to multiply that number by the business percentage you calculated earlier.

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Frequently asked questions

Depreciation is an accounting and tax calculation that puts a dollar value on the normal wear and tear of assets (things you own) that you use in your business. Instead of writing off the full value all at once, you break it down over time so your business gets a steady deduction over the full life of that asset.

The depreciation calculation can seem daunting, but you only have to do the hard part once, and after that, it's extremely simple. First, you need to calculate the "adjusted basis" of your home. This is generally its cost, plus the cost of any permanent improvements you made, minus any casualty losses or depreciation deducted in earlier tax years. Next, compare the adjusted basis you just calculated to the fair market value (FMV) of your home (not including land). Whichever number is less is the one you'll use going forward, and you never have to figure it out again. Now that you know your basis for depreciation, you can figure out the depreciation expense. According to the IRS, your home office counts as "nonresidential rental property" that gets depreciated over 39 years using the straight-line method. Basically, just divide the lesser of your adjusted basis or FMV by 39 and that's the annual depreciation.

The home office deduction allows qualified taxpayers to deduct certain home expenses when they file their taxes. These may include mortgage interest, insurance, utilities, repairs, maintenance, depreciation, and rent.

There are two basic requirements for the taxpayer's home to qualify as a deduction:

The home must generally be the taxpayer's principal place of business. A taxpayer can also meet this requirement if administrative or management activities are conducted at the home, and there is no other location to perform these duties. Therefore, someone who conducts business outside of their home but also uses their home to conduct business may still qualify for a home office deduction.

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