Guide to Deductible Business Expenses | Part 2: The Home Office Deduction
Before reading this week's post, take a gander at Part 1: Transportation, Travel, & Meals.
Have you heard of the home office deduction? If you are self-employed and use part of your home for business purposes, you may be able to deduct a portion of your expenses associated with working from home. This tax break is available to eligible small business owners and freelancers, regardless of whether your rent or own your home.
I have been working remotely for my employer due to the COVID-19 pandemic. Can I take the home office deduction?
Unfortunately, no. There is some confusion around this topic because the deduction used to be available to certain employees working remotely. However, the Tax Cuts and Jobs Act of 2017 revoked this eligibility for tax years 2018 to 2025.
Currently, only self-employed taxpayers qualify for the home office deduction.
You are considered self-employed if you work as a small business owner or independent contractor; this includes freelancers and gig economy workers such as Uber or Lyft drivers.
Sometimes independent contractors and employees engage in similar work; if you are unsure of your employment classification, ask yourself the following questions:
Did I have to fill out a W-4 or a W-9 when I was first hired? Filing a W-4 upon starting a new job indicates that you are an employee and therefore ineligible for the home office deduction; if you were required to file a W-9 instead, you are classified as an independent contractor and may be eligible for the deduction.
Do I receive a W-2 or a 1099-MISC from my employer? If you receive a W-2 at the end of the year, you are considered an employee and are therefore ineligible for the home office deduction. Receiving a 1099-MISC indicates that you are an independent contractor; in this case, you may be eligible for the home office deduction.
I work as an employee but run a business on the side. Do I qualify for the home office deduction?
Possibly! If you run a side hustle and meet additional eligibility criteria, you may be eligible to deduct business expenses on your tax return, including costs associated with running your business from home.
Example: Teacher With an Etsy Shop
Let’s say you’re an elementary school teacher with a passion for crafting. You regularly spend your evenings creating jewelry to sell on Etsy. If the workspace you use for creating, marketing, and selling your wares meets certain additional criteria, you may qualify to deduct expenses related to running your Etsy shop from home.
Do I have to itemize my taxes in order to claim the home office deduction?
Nope! The home office deduction is an “above-the-line” deduction. Also known as adjustments to income, above-the-line deductions are subtracted from your gross income to arrive at your adjusted gross income (AGI), which is used to determine your tax bill or refund for the year. Above-the-line deductions such as the home office deduction can be claimed regardless of whether you itemize or take the standard deduction.
What conditions must my workspace meet in order to qualify for the home office deduction?
In order to take advantage of the home office deduction, your business use of a space in your home must be exclusive and regular. In addition, at least one of the following criteria must be met:
Your home office or designated workspace qualifies as your principal place of business.
Your workspace is exclusively and regularly used to meet with clients, patients, or customers.
Your designated workspace consists of a separate free-standing structure used exclusively and regularly in connection to your business.
The exclusive use condition requires that your home workspace be used solely for your trade or business. It can be a separate room or other designated area; the space is not required to be marked off by a permanent partition. A separate, free-standing structure not attached to your home may also qualify.
If you use the area in question for both business and personal purposes, you are ineligible to deduct any home-related costs as business expenses.
Example: Freelance Photographer Working From Home
Perhaps you are working as a freelance photographer. You have a desk in your home used only for editing images, record-keeping, blogging, client emails, etc. This workspace meets the exclusive use requirement.
**Two exceptions exist to the exclusive use requirement. If you use part of your home as a daycare facility or to store inventory or product samples, you are not required to meet the exclusive use test in order to take this tax deduction.
The regular use criterion requires that your home workspace be used for business on a continuing basis. If your business use of the area is only occasional or incidental, it does not meet this eligibility requirement.
Principal Place of Business
Perhaps you conduct business from your home as well as another business location. In this case, determining your eligibility for the home office deduction can be a bit tricky. In addition to being exclusively and regularly used for business purposes, your home workspace must also qualify as your principal place of business. If you conduct business from home and at a separate location, consider the relative importance of the business activities undertaken at each premises.
In order to qualify as your principal place of business, your home workspace must be used regularly and exclusively for administrative or management activities related to your business, such as billing, recordkeeping, appointment scheduling, marketing activities, paying bills and taxes, ordering supplies, writing reports, etc. This requirement can be met even if you conduct most of your non-administrative and non-management activities outside the home.
If you also conduct substantial administrative or management activities at another location, your home workspace cannot be classified as your principal place of business.
Example: Self-Employed Electrician
Suppose you work as a self-employed electrician. Although you spend most of your time working at clients’ homes or businesses, you use your home office for your business’s administrative and management activities, such as phoning customers, ordering supplies, and bookkeeping. Therefore, your home office qualifies as your principal place of business.
Place to Meet Patients, Clients, or Customers
If your home workspace does not qualify as your principal place of business, you may still be eligible to deduct home office expenses if the space serves as a place to physically meet with patients, clients, or customers. If you exclusively and regularly use your home office for this purpose, you may be eligible for the home office deduction as long as this use of your home is considered substantial and integral to running your business.
Example: Self-Employed Attorney
Perhaps you work as a self-employed attorney. Although you work from a rented office space three days per week, you regularly meet with clients in your home office on Thursdays and Fridays. Even though your rented office space would be considered your primary place of business, you are still eligible to take the home office deduction because you regularly take meetings in your home in the normal course of running your business.
Use of a Separate, Free-Standing Structure
If you have a free-standing structure on your property such as a workshop, garage, studio, or barn that you use exclusively and regularly in connection with your business, you may be eligible for the home office deduction even if the structure is not used as your principal place of business nor as a space to meet with clients or customers.
Example: Backyard Carpentry Shed
Let’s say you’re a self-employed carpenter with an unattached shed behind your house. If you exclusively use the shed to store tools used only in the course of your carpentry business, you may be able to deduct expenses associated with the shed. If you were to store your personal gardening equipment alongside the carpentry tools, the shed would no longer meet the condition of exclusive use and therefore be ineligible for the home ofice deduction.
I qualify to take the home office deduction; what types of expenses can I deduct?
If you meet the necessary criteria for the home office deduction, congratulations! This deduction allows you to claim a portion of expenses that are not typically deductible for the average taxpayer.
There are two main types of deductible expenses associated with the business use of your home: direct expenses and indirect expenses.
Direct expenses are costs relating solely to the workspace itself. Examples of direct expenses include the cost of office supplies or furnishings, computer equipment, and services used exclusively for business purposes (such as a separate phone line).
Utilities used only for a standalone structure used in the course of your business (such as a workshop or unattached studio) are also considered direct expenses, as are the costs of repairing or upgrading elements of your home office.
For example, if you were to install new window treatments or light fixtures in your home office, the associated costs would be considered a direct expense as long as the upgrades were not installed anywhere else in your home.
Direct home office expenses are fully deductible under the home office deduction.
Indirect expenses are only partially deductible, based on the percentage of your home used for business purposes.
For example, if your home office takes up 20% of your home and you use the same wifi network for business and personal purposes, you may only deduct 20% of your wifi expenses as a business expense.
Expenses unrelated to the business use of your home (such as lawncare or painting a guest room) are not considered indirect expenses and are therefore non-deductible.
How do I calculate my home office deduction?
There are two methods for calculating the home office deduction; you may opt to either calculate your actual expenses or use a more simplified method.
Actual Expenses Method
If you calculate your deduction using actual expenses, you will need to determine which of your home office costs qualify as direct expenses versus indirect expenses.
Direct expenses are fully deductible, but you’ll need to calculate the business percentage of your home in order to determine what percentage of indirect expenses you can deduct.
The most accurate way to calculate the business percentage of your home is to divide the area of your workspace by the total area of your home. If each room in your home is approximately the same size, you may opt instead to divide the number of rooms in your home used for business by the total number of rooms in your house.
Once you have arrived at the business percentage of your home, use that number to calculate the deductible portion of your indirect expenses.
Although your home office deduction is limited to the amount of gross business income you earned during the year, any amount in excess of your gross income may be carried forward and claimed the following year if you use actual expenses to calculate your deduction.
Simplified Method: Using the Prescribed Rate
If you’d rather avoid the mathematical headache, you can still take advantage of the home office deduction using a simplified method provided by the IRS. To use this method, simply multiply the square footage of your home workspace by the prescribed standard rate ($5.00 for 2020).
While the simplified method is far less complex than using your actual expenses to calculate your home office deduction, there are a few downsides.
The standard rate may only be used for a maximum of 300 square feet of workspace, and it does not allow for a home depreciation deduction. Additionally, any deduction amount exceeding your gross business income cannot be carried over to the following tax year.
Do I have to itemize my taxes in order to claim the home office deduction?
Nope! The home office deduction is an “above-the-line” deduction. Also known as adjustments to income, above-the-line deductions are subtracted from your gross income to arrive at your adjusted gross income (AGI), which is used to determine your tax bill or refund for the year. Above-the-line deductions such as the home office deduction can be claimed regardless of whether you itemize or take the standard deduction on your tax return.
Will taking the home office deduction increase my chances of an audit by the IRS?
You may have been warned against taking the home office deduction for fear of raising a red flag with the IRS, but these fears are no longer rooted in reality.
In the past, claiming the home office deduction may have increased your chances of an audit, but the proliferation of home-based businesses in recent years means that more taxpayers are claiming it than ever before.
Today, taking the home office deduction is unlikely to raise a red flag; if you are legally eligible to claim it, there is no need to avoid doing so. Just be sure to maintain accurate, up-to-date records in case the IRS comes calling.
If you have questions about the home office deduction, feel free to leave a comment below or contact your friendly neighborhood accountants here at Seymour & Perry, LLC.
Stay tuned for more blog posts in our 10-part series on deductible business expenses. Subscribe below if you haven’t already!