Home Office Deduction: Reporting After Business Closure

The home office deduction is a tax break for self-employed people who use part of their home for business activities. Small-business owners and freelancers who regularly and exclusively use part of their home for work and business-related activities may be able to write off rent, utilities, real estate taxes, repairs, maintenance and other related expenses. The home office deduction can be taken on Schedule C of Form 1040 (annual tax return).

To qualify for the home office deduction, you must meet one of the following criteria:

- Exclusive and regular use: You must use a portion of your house, apartment, condominium, mobile home, boat or similar structure for your business on a regular basis.

- 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.

There are two methods to calculate your home office tax deduction:

- Simplified method: With the simplified option, you aren’t deducting actual expenses. Instead, the square footage of your space is multiplied by a prescribed rate. The rate is $5 per square foot for up to 300 square feet of space.

- Actual expenses method: The regular, more difficult method values your home office by measuring actual expenditures against your overall residence expenses. You can deduct mortgage interest, taxes, maintenance and repairs, insurance, utilities and other expenses.

The choice of whether to use the simplified deduction or deduct actual expenses depends mainly on which would net you the bigger tax deduction.

Exclusive and regular use

To qualify for the home office deduction, you must use a specific area of your home only for your trade or business. This is known as the exclusive use test. The area used for business can be a room or other separately identifiable space. The space does not need to be marked off by a permanent partition.

The exclusive-use rule doesn't mean that you're forbidden to make a personal phone call from the office. It also doesn't mean that you have to rush outside whenever a family member needs a moment of your time.

The exclusive-use test doesn't apply if you use part of your home for the storage of inventory or product samples. Your home must be the only fixed location of the trade or business. You must use the storage space on a regular basis, and it must be suitable for storage.

You must also use a specific area of your home for business on a regular basis. This is known as the regular use test. Incidental or occasional business use is not regular use. You must consider all facts and circumstances in determining whether your use is on a regular basis.

Principal place of business

To qualify for the home office tax deduction, your home office must be your principal place of business. This means that you must use the space exclusively and regularly for administrative or management activities, such as billing customers, setting up appointments, and keeping books and records.

To determine whether your home office is your principal place of business, you must consider the relative importance of the activities performed at each place where you conduct business, and the amount of time spent at each place. Your home office will qualify as your principal place of business if you meet the following requirements:

• You use it exclusively and regularly for administrative or management activities of your trade or business.
• You have no other fixed location where you conduct substantial administrative or management activities of your trade or business.

Simplified method

The simplified method for determining the home office deduction is an easier way to calculate the amount of expenses you can deduct for a qualified business use of your home. This method was introduced in 2013 and is an alternative to the calculation, allocation, and substantiation of actual expenses.

Highlights of the Simplified Method:

• Standard deduction of $5 per square foot of home used for business (maximum 300 square feet).
• Allowable home-related itemized deductions claimed in full on Schedule A (e.g. mortgage interest, real estate taxes).
• No home depreciation deduction or later recapture of depreciation for the years the simplified option is used.

How to Calculate the Simplified Method:

The simplified method uses a prescribed rate multiplied by the allowable square footage used in the home. The prescribed rate is $5 per square foot, with a maximum of 300 square feet.

Limitations of the Simplified Method:

• The simplified method can only be used for qualified business uses of one home per taxable year.
• Actual expenses related to the qualified business use of the home cannot be deducted in the same year the simplified method is used.
• The amount of the deduction computed using the simplified method cannot exceed the gross income derived from the qualified business use of the home for the taxable year, reduced by the business deductions that are unrelated to the qualified business use of the home.
• Any amount in excess of the gross income limitation may not be carried over and claimed as a deduction in any other taxable year.
• An amount that was disallowed due to the gross income limitation under the standard method in a prior taxable year may only be carried over and deducted in succeeding taxable years in which the standard method is used.

Other Considerations:

• You choose a method (simplified or standard) by using that method on your timely filed, original federal income tax return for the taxable year.
• Once you have chosen a method for a taxable year, you cannot later change to the other method for that same year.
• If you use the simplified method for one year and use the standard method for any subsequent year, you must calculate the depreciation deduction for the subsequent year using the appropriate optional depreciation table.

Actual expenses method

The actual expenses method is the regular, more difficult method for calculating your home office deduction. It values your home office by measuring actual expenditures against your overall residence expenses. You can deduct mortgage interest, taxes, maintenance and repairs, insurance, utilities and other expenses.

Direct and Indirect Expenses

Direct expenses are those that are entirely related to your home office, such as painting or repairs. These can be deducted in full.

Indirect expenses are those that benefit your entire home, such as mortgage interest, insurance, utilities, and real estate taxes. These can be deducted based on the percentage of your home that is used for business. For example, if your home office takes up 300 square feet of a 2,000 square foot home, you can deduct indirect expenses on 15% of your home.

Depreciation

If you use the actual expenses method, you are required to depreciate the value of your home. Depreciation refers to an income tax deduction that lets taxpayers recover the costs of property due to wear and tear, deterioration, or obsolescence of the property. The depreciation you must take in home office deductions is subject to capital gains tax when you sell your home.

Record-Keeping

If you plan on deducting actual expenses, keep detailed records of all the business expenses you think you'll deduct, such as equipment purchases, electric bills, utility bills and repairs. If you're ever audited by the IRS, you'll be prepared to back up your claims.

Employees are not eligible

The home office deduction is only available to those who are self-employed or small business owners using part of their home for business activities. To qualify for the home office deduction, you must use a part of your home regularly and exclusively for work. Your home office must also be your principal workplace, or you must regularly perform administrative or management tasks there.

If you don't qualify for the home office deduction, but regularly use your office for work, try to get your employer to reimburse you for your home office expenses. The reimbursement would not be taxable income so long as you properly account for your expenses.

Frequently asked questions