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How to Calculate the Home Office Tax Deduction

In order to run a business, you obviously need a place to work. Over the last decade, there has been a dramatic increase in the number of business owners who choose to work out of their homes. Previously, it used to be extremely difficult to meet the stringent requirements to qualify to deduct expenses related to your home office. However, in 1999, Congress passed a law that made it significantly easier to qualify to deduct expenses related to the business use of your home.

How to Know if You’re Qualified

To qualify as a home office, the area in question does not necessarily need to have a physical barrier from the rest of your home. For instance, your home office could be one-half of a spare bedroom. For the most part, in order to be able to deduct expenses related to your home office, you must have a part of your home that you use exclusively and regularly either:

  1. as your principal place of business, or
  2. as a place to meet with your clients.

To determine whether your home office is your principal place of business, the IRS considers both the relative importance of the activities performed at your various places of business as well as the amount of time spent at each place where you conduct your business. Even if your home office isn’t the location where you conduct most of your business, it will be treated as your principal place of business if you meet both of the following requirements:

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

For example, if you are a self-employed electrician, most of your work will obviously be done on the clients’ premises. However, as long as you do all of your administrative work in your home office, it will still qualify as your principal place of business. For reference, if you outsource some of your administrative activities (billing, for example), this will not disqualify you from meeting the above requirements.

There is one final thing to note regarding whether or not your home office qualifies for the deduction. The tax code says that the area must be used exclusively for business. So far, the IRS has held to a very literal definition of the word “exclusive.”

If you (or any family members) use the area in question for anything at all other than your business, it will disqualify you from taking the deduction. In other words, make sure that your kids are not playing in your office (on the computer, for instance) while you aren’t home.

What Can Be Deducted

Generally, once you have determined that your home office qualifies for the deduction, you are allowed to deduct any expenses relating directly to the home office (as compared to relating to your entire home). Expenses that relate directly to your home office can be deducted in their entirety. These expenses would include things such as repairs on your office or repainting of the office.

You are also allowed to deduct a portion of the total expenses you incur in the operation of your home. This portion is simply a fraction calculated by dividing the square feet of your office by the square feet of your entire home. This category can include such expenses as:

  • Homeowner’s insurance
  • Repairs and maintenance for your entire house.
  • Cleaning supplies/services.
  • Rent (if you rent your home)
  • Deductible mortgage interest (if you own your home)
  • Utilities

Depreciating Your Home

If you own your home, there is one final deduction that you can take for your home office: depreciation for your home. This works much like depreciating any other asset:

  1. Determine the fair market value and the adjusted basis of your home. (The adjusted basis is generally what you paid for it.)
  2. From the smaller of the two numbers, subtract the value of the land upon which your home is located. (A real estate appraiser can assess this value for you.)
  3. Multiply the answer to #2 (known as the basis of the building) by the fraction you’ve been using for each of your home office deductions. Your answer is known as the business basis of the building.
  4. The business basis of the building gets depreciated using a depreciation percentage each year as specified in the tax code. (The applicable percentages can be found in the instructions to Form 8829).

Should you choose to depreciate your home, be aware that there could be negative ramifications if/when you sell your home. As a result of depreciating a portion of your home, you will have a smaller adjusted cost basis when your home is sold. As such, the capital gain that you realize upon the sale of your home will be larger than it would have been had you not been depreciating it. That said, when most taxpayers sell their homes, they qualify for an exclusion that is large enough that it often nullifies the need to pay taxes on the capital gain. (Please see IRS Publication 523 for details on this exclusion.)

Is It Worth the Hassle?

Obviously, it takes some real time and effort to ensure that you are eligible for the home office deduction. You have to structure your day-to-day activities in a specific manner; you have additional records to keep; and you have to fill out a beast of a tax form (Form 8829).

However, as you can see from all of the eligible expenses listed above, the deduction for business use of your home can be a very large one. Also, many of the expenses included in the deduction are ones that you are going to be paying one way or the other (homeowner’s insurance, anyone?). Any amount you can save on your taxes from these expenses is pure money in your pocket.

In Summary

  • To qualify for the Home Office Deduction, you must use your home office exclusively and regularly as either your principal place of business or as a place to meet with clients.
  • Even if you do not conduct the majority of your business from your home office, it will still qualify if you use it exclusively and regularly to conduct administrative or managerial functions for your business and there is no other fixed location where you conduct similar activities.
  • As long as your home office qualifies, you can deduct all expenses related directly to the home office, and a portion of most expenses relating to your entire home. (The portion is calculated as the percentage of your entire home that is taken up by your home office.)

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Independent Contractor, Sole Proprietor, and LLC Taxes Explained in 100 Pages or Less

Topics Covered in the Book:
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  • Self-employment tax: What it is, why it exists, and how to calculate it,
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