Many people do not want to take home office deduction, because they have heard it will trigger an audit. In fact, if you are eligible, a home office deduction can save you a lot of money at tax time. If you’re not, claiming it can get you into big trouble.
Let’s ask yourself the following questions to see whether you are qualified for home office deduction or not.
Do you use your home office exclusively? (Exclusive Use)
Exclusive use means you use a specific area of your home only for trade or business purposes. Do not use at all for any personal purpose and do not contain personal use furnishings. If simply doing some work at your dining table, it is not enough to qualify, because the dining table is for personal use, which allows you and your family to have dinner, not for work purposes only.
The IRS is very serious about the exclusive-use requirement. The space you are using for trade or business must be used exclusively for conducting trade or business. For example, using a spare bedroom as your office, you only do work in the room, and you do not allow any others to stay and play in that room, then you can take a home office deduction for that extra room.
Is your home office the “principal place”? (Principal place of business)
You can have more than one business location for a single trade or business, but you can only claim the home office if it is where you do the majority of the work, or certain kinds of work.
These factors can help you to determine if your home office qualifies as a principal place of business: 1) the relative importance of the activities performed in each business location, such as meeting clients and selling or delivering goods or services. 2) Amount of time you spend at each location. For example, you use the spare bedroom as a dental office. You have a personal meeting with a patient in your home in the normal course of your business, even though you also have a dental office in another location, you can deduct your expenses for the part of your home use exclusively for business.
If your answers are “yes” to the above question, congratulation, you are qualified for the home office deduction. Now, let's figure out the deduction
You can determine the value of your deduction in an easy way (simplified method) and the hard way (actual expense method)
The choice of whether to use the simplified method or actual expense method is depended on which one you are eligible for, and which one can give you the biggest tax deduction. However, no matter which method you use, you must need to know the total square footage of your office space and home.
Actual expense method
If you use the actual expense method, you can deduct direct expenses in full amount, which is money spent to repair or maintain the business space. For example, if you paid $500 to hire someone to fix the wall in your home office, the full $500 will be deductible. Also, you can deduct the indirect expenses, but it is based on the percentage of your home used for business. Some indirect expenses, such as mortgage interest, insurance, home utilities, and property tax. For example, you paid $3,000 in mortgage interest and $1,000 property tax for your home in the 2018 tax year. Your home office takes up 300 square feet in a 3,000-square feet home, so you are eligible to deduct an indirect expense of 10% of your home. You are eligible to claim a deduction of $400 in indirect expenses ($4,000 in expenses, multiples by the 10% of space used in the home).
Simplified method
Starting with the tax year of 2013, the IRS introduced a simple way to compute the deduction. Rather than adding up the percentage of indirect expense and the full amount of direct expense of your home office, all you do is to use one formula if you chose the simplified method.
The rate for 2018 home office deduction is $5 per square feet with a maximum of 300 square feet, so the maximum deduction is $1,500 per year. For example, you home office is 250 square feet, you can deduct $1,250 (250 square feet multiples $5 per square feet) for the tax year.
If the portion of your home used for business is larger than 300 square feet, and the added-up indirect and indirect expense is more than $1,500, you will want to use the actual expense method. If not, keep it simple by using the simplified method.
Bonus section: For Day Care facilities
The exclusive use test does not apply if you use part of your house to provide daycare services for children or elder people. In fact, in terms of deducting home office expenses, daycare business gets slightly better treatment than another type of small businesses.
For daycare facilities, you do not need to use a room or even part of a room exclusively for the business. You can use a room of daycare during the day and use it for personal use at night and still get a home office deduction. However, if you want to claim a home office deduction for day care facility, you must comply with any state law requirements.
IRS has developed a formula to prorate your business use among the available hours. The formula contains 2 sections to multiple together: 1) The square footage used by the daycare facility out of the home’s total square footage. 2) The total hours in the year that the daycare uses the home are divided by the total hours in the year, which is 8,760 hours. Once the business percentage is calculated, then use the percentage to multiply by the indirect business expense.
For example, you use the living room and back yard as daycare center for children. Your house is 3,400 in total, and the sum of your living room and back yard is 1,300 square feet. The daycare hours are 7 hours per day including the time to prepare for the daycare and clean up after the daycare. You paid $5,000 mortgage and interest, $3,000 property tax, $2,000 utility fee, and $800 for suppliers. The formula to calculate the deduction is shown as below:
Step 1: Business percentage: (1,300 / 3,400) x {(7x 365)/8,760} = 11.15%
Step 2: Indirect business expense: $5,000 + $3,000 + $2,000 + $800 = $10,800
Step 3: Home office deduction: 11.15% x $10,800 = $1,204.41
Bottom Line
The potential deduction for home office deduction is so attractive, so you can imagine this is something many taxpayers might be tempted to abuse. That is why it can get you into big trouble if you claimed it without qualification.
For years of experience by working with clients who are audited by IRS because of home office deduction, there are some factors that can really make IRS raise the red flag. Be careful on filing for home office deduction. If you need any additional help, talk to a tax professional.
For information regarding your particular situation, contact an attorney, or a tax or financial adviser. We expressly disclaim all liability in regard to actions taken or not taken based on the contents of this blog as well as the use or interpretation of this information.
This article is not intended to give advice or to represent our firm as qualified to give advice in all areas of professional services. Any examples provided are hypothetical and for illustrative purposes only. Examples include fictitious names and do not represent any particular person or entity.