Home Office Tax Deductions
Many expenses that you incur while working from home are tax deductible-even items that you do not specifically write checks for, such as depreciation.
You can think of these expenses that the IRS allows you to deduct as falling into two major categories. First, you can deduct expenses used in the course of your businesses-telephone, supplies, postage, etc.
Second, you may be able to deduct a portion of the costs of running your business from home. Beginning with rent or mortgage interest, you can potentially deduct utilities, insurance, real estate taxes in proportion to the amount of space your office uses in your home. Repairs and improvements that relate to the business can also be deductible.
Historically, the IRS had rigid rules that often eliminated home office deductions. The regulations have been relaxed somewhat in the past few years, but it is vital to meet the IRS's specific requirements. And, as they say on their Web site, "even then, your deduction may be limited."
To deduct expenses that apply to the business portion of your home, you must meet four requirements.
- exclusive use: a space dedicated just to the business;
- regular use: a consistent and continuing use of the work area;
- for your trade or business; and
- one of these three options: your principal place of business, a place where you meet with clients or patients, or a separate, unattached structure that you use in connection with your trade or business.
What does the IRS mean by "exclusive use" in determining whether I can deduct my home office?
To the IRS, exclusive use means that a separate area of your home is used only for your trade or business. It can be a separate room or a clearly identifiable space. The space does not have to be specifically marked off.
A key point is that you cannot use the area for personal purposes. That means you cannot, for example, use your work space to pursue a hobby of family history.
Is there an exception to the IRS "exclusive use" rule in determining whether I can deduct my home office?
Yes. If you consistently use a distinct part of your home to store inventory or product samples, and if your home is the only fixed location for your trade or business, you do not have to meet the exclusive use test. Another exception is if you use part of your home for a day care business.
Can I deduct home office expenses even if I do not meet patients, clients or customers there as part of my business?
Meetings are just one of the ways to support deducting home office expenses. In addition to meeting the exclusive, regular and for your trade or business requirements, the IRS says the business part of your home must meet just one of these:
- your principal place of business;
- a separate structure (not attached to your home) that you use to pursue your trade or business; or
- a meeting place.
In other words, you do not have to meet with others to satisfy the requirements if your home work space is your principal place of business, either in your home or in a separate structure.
Can I deduct a home office if I live in a condo or rent an apartment?
You do not need to live in a house to qualify for a home office deduction, although you still need to meet the requirements set by the IRS.
If, for example, you are an interior designer and spend the majority of your time shopping for decorating products for your clients or meeting where they live, you may still qualify for the home office deduction. If you maintain your schedule and other records, have a primary telephone line and order products from your home office, you can be eligible to take the deduction.
What are some tips for meeting IRS requirements?
As in any dealings with the IRS, you will benefit from maintaining records that support your case.
- Keep a calendar and a log of your business activities so that you can demonstrate how you spend your time. (Many consultants who bill by the hour already keep these detailed records.)
- Use a dedicated business phone line and make sure it, along with your address and business name, is included in your letterhead and other correspondence.
- Be ready to document your office space with layouts and possibly photos.
How do I determine the amount of home office expense I can deduct?
Once you are sure you meet the IRS regulations for a home office deduction, you will need to take two more steps. First, compile your home-related expenses that will be eligible for the deduction. This includes a mortgage or rent payment, property tax, casualty losses and repairs. You will also calculate depreciation for the home.
Then you need to estimate the portion of the dwelling that is dedicated to your home business. This can be done by using square feet, dividing the number of square feet used by the home office by the home's total. Or you can use the proportionate number of rooms, assuming all rooms are about the same size.
You may have what the IRS calls "direct" expenses, meaning they apply only to the work area. The business can deduct the entire amount of a direct expense. Painting only the business area is an example of a direct expense.
Can I depreciate home office furniture and equipment?
Even if you do not qualify to deduct home office expenses, such as mortgage or rent, utilities and depreciation, you may be entitled to take depreciation for furniture and equipment. This would apply whether you are the business owner or are working as a home-based employee.
Even if you may have paid cash for the whole amount of a business asset, for tax purposes you will take depreciation as an expense over a number of years that are roughly the same as the expected life of the asset. This "noncash" expense will help reduce the amount of income eligible for income tax; thus business owners want to take as much depreciation as allowed by the IRS.
The rules for depreciating business furniture and equipment depend on many factors. The IRS regulates depreciation based on the type of property, the percent of time it is used for business use versus personal use and whether it was purchased originally for business use or personal use.
How does depreciation work?
Let us start with an example. If you are a professional photographer, you might buy an expensive camera which you expect to use over many years. You would like to be able to deduct this expense right away from your income tax.
But the IRS has other ideas. Since your equipment has a long expected life of use, you cannot deduct the entire expense in the first year. You are allowed to depreciate the expense over the approximate expected lifetime of the camera.
Each year, you can deduct a portion of the expense of the camera until you have reached the amount you paid for it.
How do I know how much depreciation expense I can take each year?
The simplest form of depreciation is called straight line. Basically, you divide the cost of your asset by the number of years of expected life and take that equal amount each year until you have depreciated the entire cost.
Accelerated depreciation is favored by businesses because it allows bigger amounts of depreciation expense in the earlier years of the item's life.
For example, if our photographer paid $1,000 for his or her camera and expects a 5-year life for it, he or she would be able to expense $200 per year using straight line depreciation. With accelerated depreciation, he or she would take a larger amount of depreciation in the first years and a smaller amount in the later years, still totaling the $1,000 original cost of the camera.
Why does depreciation matter?
Depreciation is listed as an expense for tax and accounting purposes, but there is no actual cash outlay by the business. Since the effect of depreciation is to conserve cash, it benefits cash flow. Stronger cash flow gives the business owner more flexibility in managing its finances and even for additional investment.