I’m going to walk you through a complete overview of the home office deduction. We’ll go over what it is, who can take it, and how to calculate it. I’ll walk you through how to use my FREE home office deduction worksheet to track and calculate your home office deduction, so let’s get started.
What is the home office deduction?
If you’re self-employed and work from home, you could save on taxes by taking the home office deduction. If you use part of your home regularly and exclusively for business-related activities, the IRS lets you write off a portion of your mortgage interest, rent, utilities, real estate taxes, repairs, maintenance, and other related expenses. So let’s walk through everything you need to know to take this deduction.
Who is this blog post for?
I want to be very clear on who this blog post is for. This blog post applies to all Schedule C businesses. In light of the 2018 tax law changes, the ways to take the home office deduction have changed a little bit. The methods we’re going to cover in this blog pertain only to Schedule C businesses. If you’re a sole proprietor, a single-member, limited liability company, otherwise known as an LLC, who has not elected to file taxes as an S Corporation, these are the methods you’ll follow in this workshop. If you’re an LLC filing taxes as an S Corporation, the method for you to claim the home office deduction is different and will be covered in a separate blog post.
What is the IRS Definition of “HOME”
Let’s start with understanding what home means in the home office deduction. IRS publication 587 defines this for us. The purpose of this publication is to provide information on figuring and claiming the deduction for the business use of your home. The term home includes a house, apartment, condominium, mobile home, boat, or similar property, which provides basic living accommodations. It also includes structures on the property, such as an unattached garage, studio, barn, or greenhouse. However, it does not include any part of your property used exclusively as a hotel, motel, inn, or similar establishment.
What does the IRS mean by “used exclusively and regularly.”
Now that you have the definition of home, there are certain qualifications you need to meet in order to take the deduction. The space you’re using for business must be used exclusively for conducting business. For example, using a spare bedroom as both your office and a guest room means you can only deduct the square footage around the desk and the space you actually do the work. If the room is used exclusively as a home office, then you can deduct the square footage of the entire room. Although your home office doesn’t have to be the only place you meet your clients, 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, or your bookkeeping.
To help you figure out if you qualify for the home office deduction, check out the awesome flow chart above from IRS publication 587. You can walk yourself through these questions to see if you qualify for taking the home office deduction.
The Two Calculation Methods
Once you qualify for the home office deduction, there are two methods to calculate your deduction, the actual expense method and the simplified method.
To use the actual expense method, you must keep receipts and records of all expenses. The calculation is a little more complicated. If you own your home, you’ll need to calculate depreciation as well. However, the deduction when you use actual expenses tends to be more significant.
The simplified method is straightforward, requires little bookkeeping, you don’t have to keep receipts, it’s a simple calculation, there’s no depreciation to worry about if you own your home, however, there is a $1,500 max.
Now we’ll walk you through each method so you can see how they work and which one might be best for you.
THE ACTUAL EXPENSE METHOD
Let’s start with the actual expense method.
The actual expense method allows you to deduct the “business use percent” of your actual expenses like cleaning, insurance, mortgage interest and real estate taxes if you own your home, rent if you rent your home, along with repairs, security system and utilities. You must have receipts and documentation to substantiate your deductions in case you’re ever audited.
Business use percent
Now I bet you’re wondering what the heck this business use percent is, so let me walk you through it. It’s nothing more than a simple calculation to find the percent of your home used for business. So let’s say your home is 2,500 square feet, and the area used for your business is 500 square feet. We take the 500 square feet and divide by the total square footage of 2,500 square feet, and that gives us 20%.
The way you calculate your actual expense depends on if you rent or own your home. I’ll walk you through how to calculate as a renter first then as a homeowner.
If you rent your home
Let’s walk through the renter scenario first. So we have $500 for the year for cleaning, $12,000 for the year for rent, and $4,000 for the year for utilities. That gives a total of 16,500 in costs that we’ll multiply by our 20%, the business use percent of our home. That equals $3,300 home office deduction, just like that.
If you own your home
Now let’s take a look at how a homeowner calculates the actual expense method. If you rent, you can take your actual expenses as long as you have your documentation. If you own your home, there is an extra step; you’ll need to depreciate the business percent use portion of your home. This does increase your deduction, but the only caveat is if you ever sell your home, you’ll need to pay taxes on the depreciation you took. Let me break this down for you. So just like the actual expenses for renting, let’s talk numbers for the homeowner, $750 for cleaning, $15,000 for the year for mortgage interest, $4,500 for the year for real estate taxes, $1,500 repairs for the year, and $4,000 in utilities for the year. That gives us $25,750. We multiply that again by our same 20%, the business percent use of our home, and we get $5,150 for the home office deduction.
Home Depreciation (The Extra Step)
Now let’s figure out the additional piece, the depreciation. So to do this, we have to take the total cost of your home when you purchased it. You’ll find this information on your closing documents that you received when you closed on your home. Then we’ll subtract the value of the land because the land is not depreciable. You’ll also find this figure on the closing documents of your home. Then we add the full cost of any home improvement since you’ve purchased. So what’s a home improvement? Home improvements include only things that increase the value of your house, not regular repairs and maintenance. An example of home improvement includes replacing your roof, rewiring your electrical, or adding on an addition. You’ll need to have receipts for all the costs that go into that, but you’ll add those costs here. Then we’ll subtract any casualty losses you sustained related to your home like flood or fire damage. This formula will give us our home’s adjusted basis.
An adjusted basis is just a tax term for the value of your home for depreciation purposes.
Let’s use real numbers so you can see how this works. Let’s say the home is worth $200,000; then, we’ll subtract $75,000 for the value of the land. Let’s say we added a new roof and another bathroom that cost $15,000. We have no damages; we won’t need that. That gives us a total adjusted basis of $140,000. We now have to take that number, and the IRS says we have to divide that by 39 years. That gives us depreciation of our home of $3,589.75 a year, but we can’t take the whole thing. Remember, we can only take 20% of that. That gives us $717.95. We can take the $5,150 of the home office deduction we calculated above. Then we add on the $717.95 of depreciation for the year for a total deduction of $5,867.95.
What if I sell my home?
When we sell the home, assuming we sell it for more than our adjusted basis, we have what is called a capital gain. Let’s say we sell them home after five years. Now, we have to recapture and pay the taxes on the depreciation. Remember, it was $717.95 a year, so we multiply that by 5. That gives us a total depreciation taken over the five years of $3,589.75.
Now we owe capital gains tax, which is 25% on the depreciation we took. So we owe $897.45 on the depreciation when we sell the home. That’s really not bad considering you took $3,589.75 in prior year deductions. You can see though how involved taking the actual expense method can be, especially if you own your own home. It can be worth all the extra work, or you can hire an accountant to take care of all of this for you so that you still get the benefits of the deduction, and you have someone helping you handle it.
Now let’s look at the simplified method, which is so self-explanatory. It is so simple. The simplified method does not require you to keep any receipts or records. You just have to qualify to take the deduction and know the square footage of your home office space. This method is the same if you rent or if you own your home. With this method, there’s no depreciation and no taxes to pay on depreciation if you sell your home. However, there is a max of $1,500. For a simple method, you’ll need to know the square footage of your home office. Let’s say the square footage is a hundred square feet. The IRS has a set rate for the simplified method of $5 per square foot. The simplified method will allow us a $500 home office deduction with no record-keeping or receipts or depreciation required on a hundred square foot home office.
The simplified method is super simple. It only has one drawback; you can only max out at $1,500. So if you had a 500 square foot home office, we multiplied that by the $5 range, that’s $2,500. However, you can only take 1,500. This is where understanding the two methods and how they’re calculated can help you. You can calculate to see which one gives you the larger deduction and if calculating and taking the depreciation on your home, if you own is worth it. Or just keep it simple and choose the simplified method each year.
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