Home office deduction: what is it and what does it depend on
Millions of Americans have been forced to work from home because of the Covid-19 pandemic. For many this is something completely new, and taxpayers wonder if it is possible to obtain tax deduction home office expenses arising in a qualifying use of all or part of a residence, which is possible as long as they meet IRS’ requirements and keep good records.
For a taxpayer to be eligible for a home office deduction, the dwelling unit must be one of the following:
The principal place of business for any trade or business of the taxpayer;
A place which is used by patients, clients, or customers in meeting or dealing with the taxpayer in the normal course of his/her trade or business;
A separate structure not attached to the dwelling unit and used in connection with the taxpayer’s trade business; or
If the dwelling is the only fixed location of the taxpayer's business, a space within it that is used regularly to store the business's inventory or product samples.
Let’s take a deeper look of these rules.
Exclusive and regular use: For all cases, a home office must be used regularly and exclusively to conduct business. The IRS allows for a "separately identifiable space". However, the IRS is strict in its interpretation of "exclusive use" of the space. Incidental or occasional use of an area is not regular use, and expenses related to such use are not deductible, even if the space has no other purpose.
There are two exceptions to this exclusivity rule. Exclusive use is not required if a residence is used as a day care facility, as long as you have a license, certification or approval as a day care center under state law, according to the IRS. The other exception is if you use the office for storage of inventory or product samples when there is no other business location.
Principal place of business: Although your home office doesn’t need to be the sole place you meet your clients or customers, it must be your principal place of business. That means you use the space exclusively and regularly for administrative or management activities, such as billing customers, setting up appointments and keeping books and records, according to the IRS.
"Principal place of business" is determined by facts and circumstances. To assess where the principal place of business is, if a taxpayer has multiple work locations, consider the relative importance of the activities conducted in each location, the quantity of time spent there, and whether another fixed location might compete as the principal place where work is done. It is important to confirm basic facts, such as where sales, personal property, and payroll taxes are paid.
A place to meet patients, clients or customers: Using part of a home as a place to meet clients allows more flexibility, and it can be deducted even if there is another principal place of business. Use of the home to meet with patients, clients, or customers must be "substantial and integral" to the business. Videoconferencing or occasional meetings may not be enough.
A separate structure: Deducting expenses associated with a structure that’s not attached but is "accessory or incident to" the home itself is the easiest standard to satisfy. It is better from an expense deduction standpoint if the structure isn’t adequate to a home, but generally, a separate structure are going to be considered adequate and therefore the home office restrictions will apply if it is located near the dwelling and expenses are shared for both the office and the house.
You can claim the deduction whether you’re a homeowner or a renter, and you can use the deduction for any type of home where you reside: a single-family home, an apartment, a condo or a houseboat. The home office deduction rules also apply to freestanding structures. You can use a studio, garage or barn space as your home office as long as the structure meets the “exclusive and regular use” requirements.
Calculating your home office deduction
The home office deduction is computed by categorizing the direct vs. indirect business expenses of operating the home. Direct expenses can be fully deducted. Indirect expenses are allocated pro rata between business and personal use. Any reasonable method can be used. Ratios based on square footage are most common, but the number of rooms used for business vs. personal use has been allowed as well. Not all indirect expenses may be included in the allocation.
You can determine the value of your deduction in two different ways:
· With the simplified method, you aren’t deducting actual expenses. Instead, the square footage of the portion of the home used for business is multiplied by a prescribed rate. The rate is $5 per square foot for up to 300 square feet of space. There is no carryover provision under the simplified method.
A taxpayer elects to use the simplified method simply by using it on a timely filed tax return. Once the election is made, it is irrevocable for that year. However, a taxpayer can alternate methods from year to year. The choice is not considered an accounting method change, and no special statement is necessary if the election changes from one year to the next.
If you use the actual-expenses method, you’re 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, according to the IRS. The depreciation you’re required to take in home office deductions is subject to capital gains tax when you sell your home. However, if you use the simplified method, depreciation isn’t a factor and you won’t be subject to the tax.
· The actual-expenses method, values your home office by measuring actual expenditures against your overall residence expenses. You can deduct indirect expenses such as mortgage interest, maintenance and repairs, insurance, utilities, real estate taxes, general home repairs, based on the percentage of your home used for business.
If you plan on deducting actual expenses, keep detailed records of all the business expenses you think you’ll deduct, such as receipts for 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.
The IRS introduced the simplified option beginning in the 2013 tax year, because the regular method requires accurate record-keeping that may be burdensome for some small-business owners and entrepreneurs.
In general, the simplified method works well for single-room offices and small operations, while the actual-expenses method works better if the business makes up a large part of the home. The choice whether to use the simplified deduction, if you’re eligible for it, or to deduct actual expenses depends mainly on which would net you the bigger tax deduction.
It is important to discuss with a tax expert to help you identify if this or other deductions are applicable to you. If you do not have a reliable accounting and bookkeeping solution in place, contact us today and start taking care of your financial future.
At Finanzeal Solutions we are ready to help you with this and even more. Know about our services here.