The IRS home office deduction has been around for some time. But in the past, many small business owners were reluctant to take it because they believed it was too difficult to calculate or that it would trigger a tax audit. Well, no more; on both accounts.
The IRS has come to recognize that there are many more owners of home-based businesses than ever before (nearly 26 million) and that a simpler way for calculating and claiming the home office deduction was needed. In January 2013, the IRS issued Revenue Procedure 2013-13 outlining a new simplified option for calculating the deduction for business use of a home. This new option became effective for taxable years beginning on or after January 1, 2013.
THE OLD METHOD
The old way (which is still available if you choose to go that route) required filing Form 8829, Expenses for Business Use of Your Home; a 43-line form that requires you to keep track of expenses and maintain receipts. Completing the form involves calculating and then allocating expenses such as mortgage interest, insurance, utilities and repairs to the portion of your home that you use as a home office. These requirements can be complex and burdensome for some small business owners.
THE NEW METHOD
The new simplified method uses a standard deduction of $5 per square foot of home used for business purposes. You need only to calculate the square footage of your home office space then multiply that by $5 to determine the amount of your deduction. That amount is then reported on Line 30 of Schedule C. All other home-related itemized deductions can be claimed in full on Schedule A.
PROS AND CONS
If you don’t like to take the time to keep good records and save your receipts, then the new method is definitely for you because it requires none of that. But it may result in a lower deduction. However, if you have a very small home office space, then the new method may very well give you a larger deduction.
The new method involves less tax preparation paperwork because you will not have to complete Form 8829. But the deduction using the new method is capped at $1500 per year based on $5 per square foot of office space for up to 300 square feet. If your home office space is larger than that, you’ll have to put in the extra effort and use the old method.
The old method allows you to take a depreciation allowance on that portion of your home that is used for business purposes which may result in a larger deduction. If you own your own home, this may be a reason why you wouldn’t want to use the new method. However, if you include depreciation as part of your home office deduction, you will have to pay capital gains tax on the total amount of depreciation you took while you were living there if you eventually sell your home and realize a profit.
Using either method, however, will not allow you to take the home office deduction if it would result in a net loss on your tax return. You can only deduct home office expenses up to the amount of any net income remaining after all other expenses have been deducted. With the old method, any unused expenses can be carried over to the next year. With the new method, they cannot. The good news is that you can choose to use either method for any taxable year.
REQUIREMENTS TO CLAIM THE DEDUCTION
There are two basic requirements that must be met, regardless of which method you use to calculate the deduction, in order to qualify for it:
1. Regular and Exclusive Use
The IRS requires that you regularly and exclusively use a portion of your home for conducting business. This does not mean that you must use the space 8 hours a day, 5 days a week. If your business requires you to work only three hours each day or maybe only three days a week, that would qualify as regular use.
Exclusive use can be a bit trickier. A specific room is easy to designate as your home office but an area in a larger room may not be as clear. If this is your situation, be sure that there is a clear division of the office space with a partition of some kind. Most importantly, the home office space must not be used for personal activities at all. If you’ve set aside the space for your home office but the kids use it to do their homework or the family gathers there to watch TV, then you violate the exclusive use requirement and would not qualify for the deduction.
If you use the office space only occasionally and its use is not essential to your business, then that would not qualify as regular or exclusive use.
2. Principal Place of Your Business
You must also be able to show that you use your home as your principal place of business. If you have a business location outside of your home, you can still qualify for the deduction if you can show that you also regularly conduct business from your home office; such as performing administrative and management duties or meeting with patients, clients or customers.
This requirement also dictates that you are actually operating a business. Using your spare room or den to take care of your personal investment portfolio or work on a hobby (even if you make money at it) probably won’t qualify because the IRS doesn’t consider these activities as a business.
One exception, however, is if your business is to provide day care services for children, the elderly or handicapped persons. If you use a portion of your house for those activities during the day, you can still use that same part of the house for personal activities during the evening and night and still qualify for the deduction.
For a full explanation of the tax deduction for business use of your home, consult IRS Publication 587.