Article Highlights:
- Qualifications
- Actual Expense Method
- Simplified Method
- Home Office Expenses for Renters vs. Homeowners
- Deduction Limitation
- How Moving Affects the Home-Office Deduction
- Other Issues
If you are a small business owner and use part of your home for business, you may be able to take the so-called office-in-home tax deduction. This deduction reduces both income and self-employment taxes. While the term “home office” is used to describe when a taxpayer uses their home for a business purpose, the space used may not be an office but may still qualify for the deduction. One of the following must apply for you to be able to deduct home office expenses. The home office:
- Must be your main place of business. OR
- Must be a place of business where, in the normal course of your business, you meet patients, clients or customers (just telephone contact with clients isn’t enough to meet this test). OR
- Must be in a separate structure that is not attached to your home, and you use it in connection with your business. OR
- Must be a place where you store inventory or samples. This place must be the sole, fixed location of your business. OR
- Under certain circumstances, must be where you provide day-care services.
Generally, except when used to store inventory, an office area must be used on a regular and continuing basis and be exclusively restricted to the trade or business (i.e., no personal use).
Two Methods – There are two methods to determine the amount of a home-office deduction: the actual expense method and the simplified method.
- Actual-Expense Method – The actual-expense method prorates home expenses based on the portion of the home that qualifies as a home office, which is generally based on square footage. The non-business portions of home mortgage interest and real property taxes continue to be deductible on Schedule A if you itemize deductions. Aside from prorated expenses, 100% of directly related costs, such as painting and repair expenses specific to the office, can be deducted. Unlike the simplified method (discussed next), the business-use part of the home is not limited to 300 square feet.
- Simplified Method – The simplified method allows for a deduction equal to $5 per square foot of the home used for business, up to a maximum of 300 square feet, resulting in a maximum simplified deduction of $1,500. You may elect to take the simplified method or the actual expense method (also referred to as the regular method) on an annual basis. Thus, you may freely switch between the two methods each year.
Additional office expenses such as utilities, insurance, office maintenance, etc., are not allowed when the simplified method is used. Prorated rent or home interest and taxes are not additionally deductible either, although 100% of home interest and taxes, within the normal Schedule A limitations, are deductible if you itemize deductions.
To determine the average square footage when using the simplified method, no more than 300 square feet for any month can ever be used, even if you have multiple businesses for which you use space in your home. If there are multiple businesses, a reasonable method to allocate between businesses is used. Zero is used for months when there was no business use or when the business was not operating for a full year. Don’t count any month when the business use was less than 15 days.
Example: Sandra begins using 400 square feet of her home for business on July 20, 2022, and continues using the space as a home office through the end of the year. Her average monthly allowable square footage for 2022 is 125 square feet (300 x 5 months = 1,500/12 = 125).
Home Office Expenses – There are differences as to which prorated home expenses are deductible by renters and homeowners when computing the actual expense method, as illustrated in the table below.
| Prorated Expense | Own | Rent |
|---|---|---|
| Mortgage Interest | X | |
| Property Tax | X | |
| Rent or Lease Payments | X | |
| Homeowner's Insurance | X | |
| Renter's Insurance | X | |
| Utilities | X | X |
| Depreciation | X | |
| Home Maintenance | X | X |
Note that the principal payments made on a home loan are not eligible expenses. Instead, homeowners claim a deduction for depreciation on the office portion of the home’s basis.
Home Office Deduction Limitation – Even if you qualify for a home-office deduction, your deduction is limited to the business activity’s gross income, which for this purpose is defined as the activity’s gross income, reduced by the home expenses that would be deductible if there were no business use (e.g., mortgage interest, property taxes, certain casualty losses), and the business expenses unrelated to the home’s use. When using the actual expense method, the disallowed amount will be carried over to the next year subject to the same limitations. However, there’s no carryover when using the simplified method.
| Example: Let’s say you use 20% of your home for business, have gross income of $6,000 from the business and have the following expenses: | |
|---|---|
| Deductible mortgage interest (20%) | $1,500 |
| Real estate taxes (20%) | $1,000 |
| Total | $2,500 |
| Expenses not related to business use of the home (100%): | |
| Supplies | $ 500 |
| Advertising | $1,300 |
| Telephone | $200 |
| Total | $2,000 |
| Otherwise, nondeductible expenses: | |
| Home Maintenance (20%) | $200 |
| Home Utilities (20%) | $350 |
| Home Insurance (20%) | $250 |
| Total | $800 |
| Depreciation (20%) | $1,600 |
| Based on the above expenses, you figure your deduction limit as follows. | |
| Gross income | $6,000 |
| Less: | |
| Deductible mortgage interest (20%) | $1,500 |
| Real estate taxes (20%) | $1,000 |
| Expenses not related to business use of the | |
| home (100%) | $2,000 |
| Total | $4,500 |
| Deduction limit | $1,500 |
| Note: If the home is rented, the interest and taxes would be replaced by the rental expense. |
Rent vs. Own: What Happens If You Move or Sell the Home?
Rent – When you pay rent for your home that you use partly for business, move, and then use space at the new location as a home office, for the year of the move, you’ll need to figure out the deduction separately for each home office based on the specific expenses and business use area of each home. If you don’t use space at your new living quarters for business purposes, then your home-office deduction for the year of the move will need to factor in just the expenses for the time you lived in the first home.
Own – If you own the home and sell it after having lived in it for any two of the five years prior to the sale date, you can exclude up to $250,000 of gain ($500,000 for a married couple). However, you cannot exclude the part of any gain to the extent of depreciation you claimed for the home after May 6, 1997. For gain exclusion purposes, it makes a difference whether the home office was within the home itself or in a separate structure on the same property. If within the same structure, the exclusion will apply to the entire gain from the home (other than the depreciation component). If the office was within a separate structure, then the sale must be treated as two sales – one for the home and one for the office – and the gain from the office portion cannot be excluded.
Additional Issues That May Apply – As with everything tax, there are always special rules.
- Multiple Businesses – If there are multiple businesses, only one method may be used for the year – either the regular or simplified.
- Mixed-Use Property – If you have a qualified business use of a home and a rental use of the same home, you cannot use the simplified method for the rental use.
- Taxpayers Sharing a Home – If you share a home (for example, with roommates or a spouse, regardless of filing status), and if otherwise eligible, each occupant of the home may use the simplified method but not for a qualified business use of the same portion of the home.
As an example, a husband and wife, if otherwise eligible and regardless of filing status, may each use the simplified method for a qualified business use of the same home, for up to 300 square feet of different portions of the home. - Depreciation Rate When Switching Methods
- – When the simplified method is used and you subsequently switch to the actual expense method, there are no special adjustments, and the depreciation is determined in the normal manner.
Business use of the home is deducted on a self-employed individual’s business schedule. So, for example, if you are a sole proprietor who reports your business income and expenses on Schedule C, that’s the form where the home office deduction will be claimed.
Just for the record, please note that from tax years 2018 through 2025, employees who use part of their home for work purposes are not able to deduct office in home expenses, even if they would otherwise meet one of the eligibility requirements discussed above. These expenses fall under the miscellaneous itemized deductions category subject to a 2% of AGI reduction that was suspended by the 2017 tax reform bill.
If you have concerns or questions about how the home-office deduction applies to your specific circumstances, please give this office a call.
