The home office deduction is one of the most significant tax benefits of running a small business out of your home. While the tax benefit often would be sufficient enough to prevent you from moving to a dedicated office space once the need arises, it should be taken advantage of until then. Many self-employed individuals tend to work from a home office in the beginning but often ignore the available tax deductions.
Like all tax deductions, there is some record-keeping involved to accurately claim your home office tax deduction. Most people turn to a home office deduction worksheet to simply the final calculations.
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The are two requirements to qualify for a home office deduction. First, you must use a portion of your home exclusively for conducting business on a regular basis. Second, your home must be your primary place of business.
What Does Exclusively for Conducting Business Mean?
The IRS has created six instances that meet the definition of "Exclusively conducting business" in a part of your home:
Exclusively and regularly as a principal place of business for a trade or business
Exclusively and regularly as a place where patients, clients or customers are met in the normal course of a trade or business
As a separate structure that's not attached to a home that is used exclusively and regularly in connection with a trade or business
On a regular basis for the storage of inventory or product samples used in a trade or business of selling products at retail or wholesale
For rental use
As a daycare facility
What Does "Home" Mean?
The IRS provided three guidelines to define what "home" means.
Includes a house, apartment, condominium, mobile home, boat or similar property
Includes structures on the property, like an unattached garage, studio, barn or greenhouse
Doesn't include any part of the taxpayer's property used exclusively as a hotel, motel, inn or similar business
Make sure you meet these requirements as a lot of folks took advantage of this deduction when it was first rolled out. You don't want to risk a home office deduction audit by the IRS.
What Expenses Can Be Included in the Home Office Tax Deduction?
Expenses that can be included in the home office tax deduction are referred to as qualified expenses. Qualified expenses include any expenses for business use of your home. As a general rule, you cannot deduct expenses for parts of your home that are not used for business.
For example, if you host clients in your home, landscaping expenses are still not deductible because while landscaping may provide a more professional appearance for your home, it is not a portion of your home that is actually being used for business.
A Quick Overview of the Two Methods Used to Calculate Your Deduction
There are two ways you can calculate your deduction and choosing the right method is based entirely on your situation. The methods are referred to as the simplified option and regular method. Selecting the most appropriate method is based on how much your home you use for business and how much your annual home office business expenses are. This will not only determine the total available amount to deduct but also whether it is worth the effort required for the regular method.
The Simplified Option
The simplified home office deduction calculation is straightforward, easy to use, and requires minimal documentation. It was introduced for tax years starting on or after January 1, 2013 for this very reason. The regular method can be considered too cumbersome for small home-based businesses so many home-businesses found it less expensive to not take the deduction but also not pay for the additional record-keeping that was required.
It is important to keep in mind that choosing the simplified option does not change the criteria for how qualifies for the home office deduction in general.
How to Calculate the Simplified Option and Important Tax Notes
To calculate the simplified home office deduction you simply multiply the square footage of your home used for business by $5 per square foot. As a result, your maximum deduction amount is $15,000.
The maximum square footage you can use is 300 square feet. If your home office is larger than 300 square feet you have two options. First, you can use the simplified option and simply cap your calculation at 300 square feet. Second, you can use the regular method.
Any traditional home-related itemized deductions can still be claimed in full on Schedule A. This would be expenses such as mortgage interest and real estate taxes.
You cannot take the home depreciation deduction or, in future years, recapture depreciation for years that the simplified option was used.
The Regular Method
The regular method uses your actual expenses to determine the applicable tax deduction amount. This means you will need to track the actual expenses of your home office which will include expenses such as your mortgage interest, insurance, utilities, general home repairs, and depreciation.
Along with tracking these expenses you will need to prorate the deductible amount based on what percentage of your home you used.
Tracking all of the applicable expenses can be taken care of within your current bookkeeping system regardless of whether you do it yourself in excel, use bookkeeping software, or hire someone to handle this for you. Like all tax deductions that require documentation, you will need to make sure to keep receipts of your expenses.
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The Simplest Do It Yourself Option - A Home Office Deduction Worksheet
If you are already keeping track of your expenses on your own then using a spreadsheet with all of the calculations built-in should be a straightforward process. If the spreadsheet has the necessary calculations built-in then are a few tax definitions worth remembering. As always, talking to a tax professional whenever you have questions is recommended. They can also double-check your work for you.
Part 1: Determine the Part of Your Home is Used For Business
With the regular method, you will be tracking all of your home expenses and your home office-related deduction is based on the part of your home used for business purposes. To get started you must determine how much of your home is used for business.
If you use an entire room then you can take the square footage of your entire room to determine what percentage of your home is used for business. If you are only using part of a room then you can only use the portion of the room dedicated to business.
Since smaller areas, such as the square footage of desk space, can be relatively small those situations are often best served by using the simplified method. Either way, the calculation is the square footage of your dedicated office space divided by the total square footage of your house.
Ensuring this calculation is accurate is essential to a majority of the additional calculations required to claim this deduction.
Part 2: Determining Your Allowable Deduction
To determine your allowable deduction it is essential to understand the difference between Direct Expenses and Indirect Expenses.
Direct expenses are expenses tied directly to your business. While it is a slight oversimplification the easiest way to think about direct expenses is by asking yourself this question - "Would I incur this household expense if I did not have a business?"
For example, if you have a dedicated business phone line then it is considered a direct expense. If you did not have a business, then you would not have a dedicated business phone line.
Indirect expenses are those which would exist even if you did not have a home business. For example, you will pay real estate taxes on your home and insurance on your home regardless of whether or not you operate a business out of it.
Understanding the distinction is important because you can typically deduct 100% of your direct expenses but your indirect expenses are prorated based on the percentage of your home used for business. If you pay $100 in real estate taxes and use 10% of your home for business purposes then your home office deduction in relation to your real estate taxes is $10 (10% of $100).
On the IRS form this section focuses on four expense categories: casualty losses, deductible mortgage interest, and real estate taxes. Most of time these will all be indirect expenses but there can be situations where there are direct casualty losses.
Part 3: Determining Your Deduction Limit
The next step is determining your deduction limit. There are clearly defined limitations on the amount your home office deduction. Your deduction limit is based on your gross business income. If you generate more gross business income than your total expense amount then you will be able to deduct all of your expenses. If your expenses exceed your gross income then you will not be able to deduct all of your expenses.
Similar to determining your allowable deduction, determining your deduction limit will include both direct and indirect expense calculations. The IRS has defined the following categories of expenses for this calculation: excess mortgage interest, excess real estate taxes, insurance, rent, repairs and maintenance, utilities, and other expenses.
When looking at the "other expenses" category remember this is for home office expenses only. This is not designed for all other business expenses. That is taken care of elsewhere on your tax return.
The final piece of your deduction limit is any carryover home office deductions from the prior year. Since your limit is tied to your gross business income there may be years are cannot take your full deduction. You don't lose your excess - it carries over to the next year.
Part 4: Final Calculations
The final portion of worksheet includes a few additional calculations but all of the information needed is either something you will already have from prior year tax returns or a one-time calculation. Your carryover information will be on your prior tax return. The depreciation of your home is a calculation using the MARCS depreciation table provided by the IRS.
If you dig into the calculations on the spreadsheet you will notice there are several built in calculations which input the lesser of two values. This is because several lines on the IRS form require the lesser of two or three variables to be entered into a line.
Is a Home Office Deduction Worksheet Right For You?
Time - If you are planning on using a worksheet the time required to complete it is minimal but it is an additional bookkeeping task/tax preparation task that will take some time.
Tax Preparation Services - If you are using a tax preparation service there is no need to use this worksheet as it would be a duplicative effort. At the same time, taking a look at the worksheet may help you identify opportunities for additional deductions.
Accounting Principals - While the math itself is straightforward, it is important to feel comfortable with the underlying accounting and taxation principals. If you are not comfortable with this but want to take over this work in the future, you can fill out the worksheet yourself and then compare it to the worksheet created by your tax preparer. They should be willing to discuss any differences and explain any items you need assistance with.
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