Do you think that having a business means you get a home office tax deduction? Here’s what to know before you take it.
Home Office Deduction Review
The home office tax deduction is a tax benefit that allows self-employed individuals who work from home to deduct certain expenses related to their home office from their taxable income.
To qualify for the home office tax deduction, you must meet certain criteria.
- First, your home office must be used regularly and exclusively for business purposes. This means that the space must be used as your primary place of business or used regularly for meetings with clients or customers.
- Additionally, the home office must be a separate space in your home that is used solely for business activities, and not used for personal purposes. If you use your office 60 hours a week for work and 1 hour a week for paying bills and other personal tasks, you can’t claim the home office deduction.
To claim the home office tax deduction, you will need to file Form 8829 with your tax return. The amount of the deduction you can claim will depend on the size of your home office and the amount of expenses you can allocate to the space.
Actual Expenses Method for the Home Office Deduction
There are three types of expenses you can claim with the home office deduction.
- Direct expenses: Expenses that are directly related to your home office, such as adding brighter lights or getting a dedicated business phone number.
- Indirect expenses: Expenses that are indirectly related to your home office, such as the portion of your utility bills and general maintenance expenses that can be attributed to the office space.
- Depreciation: You generally must claim depreciation based on the value of your house itself (not including the land). Depreciation is the line item that can end up causing problems later.
For direct expenses, you simply save the receipts and deduct the full amount.
For indirect expenses, it goes by square footage. For example, if your home office is 100 square feet and your home is 1,000 square feet, you can deduct 10% of your electric bill.
Depreciation lets/requires you to deduct part of your home’s value over 39 years. It’s generally:
- Your home’s purchase price minus the value of the land
- You may have to add in major improvements (such as renovations) or deduct casualty losses (such as unrepaired storm damage)
- Divide that by 39
For example, you bought a $600,000 home. $210,000 was land value and $390,000 was for the house itself. Your annual depreciation deduction is $390,000/39 = $10,000 per year.
Note: If you buy your home in the middle of the year, you’ll take a partial deduction that year and a partial deduction in the 39th year (if you keep it that long).
Simplified Home Office Tax Deduction
You can also choose to use the simplified home office tax deduction instead of your actual expenses plus depreciation. You get your office size in square feet times $5.
There’s a maximum of 300 square feet, so the maximum annual deduction is $1,500.
Home Office Tax Deduction Trap 1: Extra Taxes When You Sell Your Home
If you use the actual expenses method for the home office deduction, you may have to pay extra taxes when you sell your home. (If you use the simplified method, this doesn’t apply.)
Let’s say that you bought a house for $100,000 and sold it for $150,000. Normally, you’d have a $50,000 gain because you get to deduct your purchase price from the selling price.
But let’s say that you depreciated $25,000 through the home office deduction. If you got to deduct the full $100,00 purchase price and $25,000 in depreciation, you’d be getting to deduct the same $25,000 twice.
Remember, depreciation lets you deduct your purchase price over time.
The way the IRS prevents you from getting a double deduction is called depreciation recapture. When you sell a property you depreciated, you’ll normally have to pay taxes on the depreciation.
The tax rate for depreciation recapture is usually 25%.
In addition, the personal home sale capital gain exclusion does not offset depreciation recapture even if your capital gain is less than the maximum exclusion amount.
So in the example above, you end up with:
- $100,000 purchase price
- $150,000 selling price
- $25,000 depreciation
- Capital gain = $150,000 – $100,000 = $50,000 (This is less than the home sale capital gain exclusion, so you’ll only pay capital gains tax on this part if this wasn’t your primary residence.)
- Depreciation recapture = $25,000 (taxed at 25%)
In some cases, your depreciation recapture might be lower, but you’ll probably end up needing to hire a tax professional to sort everything out when you sell your home.
But before you run away from using the actual expenses method to avoid having to deal with depreciation, keep these things in mind:
- Your actual expenses might be way more than the $5 per square foot you get with the simplified option
- Unlike the 300 square feet / $1,500 maximum with the simplified option, there is no deduction limit for the actual expenses method
- Considering both self-employment taxes and income taxes, you’ll probably save more than 25% in taxes when you claim the home office deduction
- You get to save or invest the tax savings until you sell your home and have to pay taxes on depreciation recapture
So depreciation recapture isn’t really automatically bad unless you weren’t aware it was coming or got a surprise tax bill because you missed it.
Trap 2: You’re a W-2 Employee
With more jobs moving to work from home, a lot of employees are feeling left out. You don’t get to claim the home office deduction just because you work from home.
You have to be self-employed. If you have an employer, you have to get reimbursed for your expenses by your employer.
Trap 3: You Used Your Home Office for Something Else
The IRS is really, really, really picky about using your home office ONLY for business. You can’t take the deduction if you:
- Work in your office during the week and use it for other things on the weekends
- Use your home office as a guest room
- Pay bills, shop online, or do other personal tasks on the computer in your home office
- Let your kids play games on your computer in your home office
- Do anything else besides business activities
But the good news is that your office doesn’t have to be an entire room. If you have a dedicated corner that’s only for work and use another part of the room for personal activities, you can deduct the square footage of your workspace.
Trap 4: You Have Another Office
If you have another office, you generally can’t claim the home office deduction even if you only use it for business. So if you split your time between a coworking space or rented office and your home, no home office deduction for you.
The IRS will sometimes allow a home office deduction if you have another workspace and use it for completely different purposes. Examples include:
- A rented office where you only meet clients and do other work in your home office
- Sound studios, kitchens, machine shops, and other spaces where you do manual labor but take care of office work in your home office
- Storage spaces where you don’t have any place to work and do office tasks at home
Trap 5: You Don’t Have Regular Office Work
Another common mistake is to claim the home office deduction when you have a business that doesn’t have any regular office work.
Now your office work doesn’t have to be a lot. It could be as little as bookkeeping and setting appointments.
But if you’re doing something like working for a gig economy app or doing subcontracted work where you just have to show up at a job location, you’ll need to be able to explain how you’re regularly using your home office. The IRS will also often take a closer look at whether you’re exclusively using your office for business or are just saying you are to get the deduction.
Talk to Your Tax Advisor
Don’t fall into a home office tax deduction trap or get surprised by something like depreciation recapture. Talk to your tax advisor before you set up your home office or at least before you claim the deduction for the first time.