CHAPTER 18
Home Office Deductions
Today over 40 million Americans work at home at least some of the time, and the number is growing. Computers, smartphones, and the information highway make it easier and, in some cases, more profitable to operate a home office. The U.S. Small Business Administration reported that 52.3% of all small businesses with no paid employees and 23.3% of those with paid employees are home-based and that they generate $161 billion in annual revenue.
As a general rule, the cost of owning or renting your home is a personal one and, except for certain specific expenses (such as mortgage interest, real estate taxes, and casualty losses), you cannot deduct personal expenses. However, if you use a portion of your home for business, you may be able to deduct a number of expenses, including rent or depreciation, mortgage and real estate taxes, maintenance, and utilities.
The SBA has said that the average home office deduction is $3,686, but this was some time ago. On the nearly 25 million Schedule C filers in 2014 (the most recent year for statistics), home office deductions were claimed by nearly 9.5 million filers (the average write-off by those who claimed home office deductions was not provided).
The deduction may take the form of a write-off of your actual expenses or an allowance according to an IRS-set amount called the simplified method. Whichever type of write-off method you use, the result is a home office deduction.
The deduction is allowed for both self-employed individuals and employees who meet special requirements.
This chapter covers home office expenses; however, you need not use your home as an office to claim this deduction. Home office is simply a name assigned to a category of deductible business expenses. For example, you may use your garage to do mechanical repairs, or a greenhouse to grow plants for sale. The expenses related to these uses may be treated as home office expenses.
It has long been thought that claiming a home office deduction is an automatic red flag for an audit. However, there are no statistics to show that this is true. If you meet the tests for claiming a home office deduction as explained in this chapter and you have proof of your expenses, you should have nothing to fear, even if your return is questioned.
For more information about home office deductions, see IRS Publication 587, Business Use of Your Home.
Home Office Deductions in General
Whether you own your home or rent it, you may be able to deduct a portion of the costs of your home if you use it for business. This is so for both employees and self-employed individuals. However, the law is very strict on what constitutes business use of a home. First, you must use the portion of your home exclusively and regularly for business. The home office must be one of the following:
Your principal place of business,
A place to meet or deal with patients, clients, or customers in the normal course of your business, or
A separate structure (not attached to your house or residence) that is used in connection with your business.
Exclusively and Regularly
Exclusive use of a home office means that it is used solely for your business activities and not for personal purposes, including investment activities. If you have a spare bedroom or a den that you have equipped with a computer, telephone, and perhaps a fax/modem, you cannot meet the exclusive use test for a home office if you also use that room as a guest room or family den. A kitchen will never qualify even though it is used for a legitimate business purpose because it is also used for personal reasons (although a portion may be used solely for business in some cases).
The exclusive use test does not require you to set aside an entire room for business purposes. You can meet this test if you clearly delineate a portion of a room for business. It must be a separately identifiable space. However, you need not mark off this separate area by a permanent partition to satisfy the separately identifiable space requirement.
The fact that you have some personal papers in your home office, however, won't disqualify you from meeting the exclusive use test.
There have been several cases that help to define exclusive use. It appears that if a taxpayer or family member merely walks through a room used as a
home office, this nominal use does not prevent the taxpayer from meeting the exclusive use test. However, even occasional use of a space by family, relatives, or other guests prevents a taxpayer from meeting the exclusive use test.
There are two important exceptions to the exclusive use requirement: day-care facilities and storage space. Each of these exceptions is discussed later in this chapter.
The home office must also be used on a regular basis for your business activity. This determination is based on all the facts and circumstances. There is no minimum number of hours to meet. Occasional or incidental use of a home office will not satisfy this requirement, even if such space is used exclusively for business purposes.
Principal Place of Business
Your home office is treated as your principal place of business if it is the place where you conduct your business. It may be your prime activity or a sideline business. As long as it is the main location for the particular activity, it is your principal place of business. Generally, this means the location where you earn your money. However, one court has recognized that a musician who spends considerably more time using one room in a home for practice so that she can perform with symphonies and make recordings can treat that room as the principal place of business. It remains to be seen whether this reasoning will be extended to other types of professionals—for example, an attorney who prepares and rehearses his opening and closing arguments in a home office.
Your home office is also considered to be your principal place of business if it is used for substantial managerial or administrative activities and there is no other fixed location for such activities.
Examples of substantial administrative or management activities include:
Billing customers, clients, and patients
Forwarding orders
Keeping books and records
Ordering supplies
Reading professional or trade journals and papers
Scheduling appointments
Writing reports
Even if you perform administrative or management activities at places other than your home office, you can still take the home office deduction if you fall into one of the following categories:
You do not conduct substantial administrative or management activities at a fixed location other than your home office, even if such activities are performed by other people at other locations. For example, another company handles your billing from its own place of business.
You carry out administrative or management activities at sites that are not fixed locations of the business in addition to performing the activities at home. For example, you do these tasks in your car or in a motel room while on the road.
You conduct insubstantial amounts of administrative and management activities at a fixed location other than the home office. For example, you do minimal paperwork at an office—not your home office—once in a while.
You conduct substantial nonadministrative and nonmanagement business activities at a fixed location other than a home office. For example, you meet with or provide services to customers, clients, or patients at a fixed location other than your home office.
You have suitable space to conduct administrative or management activities outside your home but instead choose to use your home office for doing these activities.
More Than One Business
If you are an employee and also conduct a sideline business from a home office, such as actively selling on eBay, Amazon, or Etsy, you may deduct your home office expenses for the sideline business. The business activity from the home office need not be your main activity; the home office simply must be the principal place of business for the sideline activity.
However, if you conduct more than one activity from a home office, be sure that each activity meets all home office requirements. Otherwise, you may lose out on deductions. For example, if you are an employee and also have a business that you run from your home, if you use the home office for your employment-related activities (and not for the convenience of your employer), then you fail the exclusive use test for the home-based business. You will not be able to deduct any home office expenses even though the home office is the principal place of business for the home-based activity.
Place to Meet or Deal with Patients, Clients, or Customers
If you meet with patients, clients, or customers in a home office, you can deduct home office expenses. The home office need not be your principal place of business. You can conduct business at another location, and your home office can be a satellite office. However, if you use your home office only to make or receive phone calls with patients, clients, and customers, you do not meet this test. While making or receiving phone calls can arguably be viewed as dealing with patients, clients, or customers, the IRS does not view it as such.
This test generally allows professionals—attorneys, doctors, accountants, architects, and others—to deduct home office expenses. Even though they have another office, they can still use a home office and deduct related expenses. Of course, the meeting or dealing with clients and others must be more than occasional; it must be on a regular basis. However, the home office must be used exclusively for business. You cannot use it for personal activities during the time when it is not used for business.
Separate Structure
If you have a separate freestanding structure on your property, you can treat it as a home office if you use it exclusively and regularly for your home office activity. A separate structure may be a garage, a studio, a greenhouse, or even a barn. It need not be an office in order for expenses to be deducted as home office expenses. Nor does the separate structure need be the principal place of your business activity. Further, it need not be a place to meet or deal with patients, clients, or customers in the normal course of your business. It simply must be used in connection with your business. Expenses related to a separate structure are deductible without regard to the gross income limit (explained later).
What constitutes a separate structure? The answer is not always clear. An attached garage is not viewed as a separate structure, nor is a freestanding garage 12 feet from the house because of its close relationship to the home. If your local real estate law treats a separate structure as appurtenant to the house, then it is not a separate structure for purposes of the home office deduction rules.
Examples of separate structures that may qualify as home offices include an artist's studio, a florist's greenhouse, and a carpenter's workshop.
Special Requirements for Employees
Telecommuters take heart. If you use your home for business, you can deduct home office expenses provided your use is for the convenience of your employer and meets the other home office requirements. However, this is not an easy standard to satisfy. There is no hard-and-fast rule for proving that your use of a home office is for the convenience of your employer. Neither the tax law nor regulations provide any guidelines.
Your home office use is not treated as being for the convenience of your employer simply because it is appropriate or helpful to your job; there must be a real need on the part of your employer for you to use an office at home. In this age of computers, if your employer allows you to telecommute from a home office because it suits your schedule, this is not necessarily for your employer's convenience. As long as your employer provides you with an office, there must be some other compelling reason for you to use a home office for business. Simply getting a letter from your employer that the home office use is for the employer's convenience may not be enough to satisfy the IRS if your return is questioned. But if your employer has no office space for you to use so that telecommuting is the only arrangement feasible, then clearly such arrangement is for the convenience of the employer. Of course, there may be situations where it is not clear whether the arrangement is for the convenience of the employer. Then, factors such as office space, arrangements with other workers, and other factors must be considered. Usually, teachers cannot claim a home office deduction for space in their home used to do lesson plans and grade papers because their classrooms are their principal place of business. However, one teacher employed as an adapted physical education teacher with primary responsibilities of implementing physical education programs for students with special needs was allowed a deduction. She used the space in her home to conduct administrative and management activities related to her work and her district did not provide her with space for these tasks. She also used space in her garage to store equipment and the district was aware of this arrangement. Using her home office was for the convenience of her employer.
If you employ your spouse, you may be able to deduct home office expenses by requiring your spouse to use the home office for your convenience. There have been no cases or rulings testing this arrangement, but if there is a real need on your part for it, the arrangement just might work.
You cannot claim a home office deduction if you rent a portion of your home to your employer and then perform services in it as an employee. If you do rent space to your employer, the rent is still taxable income to you.
Actual Expense or Simplified Method
You can choose the way in which to figure your home office deduction. You can deduct the actual expenses for the business use of your home or rely on an amount under a simplified method. You can change your election from year to year.
Why use the actual expense method. You probably can deduct a greater amount if you use the actual expense method, especially if your home office space is greater than 300 square feet or you have unusually high utility costs or other expenses related to the home office. It also makes sense to use the actual expense method if the home office deduction is greater than the gross income limit (explained later in this chapter). The unused home office deduction (the amount in excess of the gross income limit) can be carried forward indefinitely, to save you taxes in future years.
Why use the simplified method. You can eliminate some time-consuming recordkeeping by relying on the IRS-set deduction amount for your home office. You do not have to track and retain records showing what you paid for electricity and other expenses that are part of the home office deduction. Also, tax preparation time is greatly reduced by using this easy method.
Actual Expense Method
If you deduct the actual expenses related to your home office, some expenses are directly related to business use and are fully deductible. For example, if you paint your home office, the entire cost of the paint job is a business expense. Other expenses are indirectly related to business use of your home office; rather, they relate to your entire home. Indirect expenses include:
Deductible mortgage interest
Real estate taxes
Depreciation
Rent
Utilities
Insurance
General repairs to the home (such as servicing the heating system)
Security systems
Snow removal
Cleaning
Only the portion of indirect expenses related to the business use of your home is deductible. How do you make an allocation of expenses? If you have 5 rooms and use one for business, can you allocate one-fifth of expenses, or 20%, for business? The answer is yes if the rooms are more or less the same size. This is often not the case. If rooms are of unequal size, you allocate expenses based on the square footage of business use. Determine the size of your home; then determine the size of your home office. Divide the size of your home office by the size of your home to arrive at a percentage of business use.
Once you have determined your business percentage, you apply this percentage against each indirect expense.
You apply the business percentage against deductible mortgage interest. You can include a second mortgage and deductible points in this figure. The portion of your mortgage interest not treated as part of your home office deduction continues to be deductible as an itemized deduction on Schedule A.
Casualty losses not covered by insurance may be either an indirect or direct expense, depending upon the property affected by the casualty. If, for example, your home office is damaged in a storm and you are not fully compensated by insurance, you claim your loss as a direct expense. If, however, the damage is to your entire home (such as a roof leak), you treat the loss as an indirect expense. Remember that the limits on deducting casualty losses to nonbusiness property ($100 per incident/10%-of-adjusted-gross-income floor) do not apply to business casualties. See Chapter 17 for more information on deducting casualty losses.
If you rent your home, you can deduct the business portion of rent as an indirect expense. If you own your home, you cannot deduct the fair rental value of your home office. However, you can claim depreciation on your home office. Usually, depreciation is based on a 39-year recovery period, the period that applies for commercial property. However, when a landlord of a multi-unit apartment building uses one room within the unit he lives in as a home office, that room can be depreciated as residential realty using a 27.5 year recovery period; 80% or more of the gross rental income must be from rental income within the dwelling units within the building to qualify as residential property. In a Tax Court case, a couple who ran an adult home care service from their residence was allowed to use a 27-year recovery period. See Chapter 14 for more information on depreciation.
Generally, utility expenses—for electricity, gas, oil, trash removal, and cleaning services—are treated as indirect expenses. The business portion is part of your home office deduction; the nonbusiness portion is not deductible. However, in some instances, you may be able to deduct a greater portion of a utility expense. For example, if you can show that electrical use for your home office is greater than the allocable percentage of the whole bill, you can claim that additional amount as a direct expense.
The business portion of a homeowner's insurance policy is part of your home office deduction. It is an indirect expense. If you also pay additional coverage directly related to your home office, treat the additional coverage as a direct expense. You may, for example, carry special coverage for your home office equipment (computer, library, etc.). In fact, if you do not now maintain special coverage for home office equipment, you should check your homeowner's policy to see if damage or loss to your business equipment would be covered. You may think your computer is covered, but some homeowner policies may exclude business equipment or inventory. Also check whether your homeowner's policy covers personal liability for on-premises injury to patients, clients, and customers who visit your home office. Again, you may have to carry additional insurance for this type of liability.
Repairs may be direct or indirect expenses, depending on their nature. A repair to a furnace is an indirect expense; a repair to a window in the home office itself is a direct expense.
A home security system for your entire home can give rise to 2 types of write-offs. First, the business portion of your monthly monitoring fees is an indirect expense. Second, the business portion of the cost of the system itself may be depreciated. This depreciation also becomes part of your indirect expenses.
You cannot deduct expenses for any portion of the year during which there was no business use of the home. If you use your home office for only part of the year for business, you can take into account only expenses for the home related to that portion of the year.
Telephone Expenses
Telephone expenses are not part of your home office deduction. They are separately deductible. However, if you maintain a home office, there is a special rule that limits a deduction for a telephone line: You may not deduct the basic monthly service charge for the first telephone line to your home as a business expense. You can, however, deduct business-related charges, such as long-distance calls for business or call answering, call waiting, and call forwarding. You can also deduct the entire phone bill of a second phone line used exclusively for business. You can deduct any additional lines used for business, such as a separate phone line to which you hook up your scanner/fax/copier machine. These restrictions may not apply to cell phones, although the IRS has not ruled on this point.
Nondeductible Expenses
Not every home-related expense can be treated as a home office deduction. For example, the cost of landscaping cannot be treated as a home office expense because it is a capital expense.
Deduction Limits
The home office deduction cannot exceed your gross income from the home office activity. For those who conduct their primary business from home, this gross income limit poses no problem. Income from the home office activity usually will more than exceed home office expenses. Thus, for example, if a dentist conducts his or her practice from a home office, there should be no problem in deducting all home office expenses. For those who use a home office for a sideline activity, however, the gross income limit may pose a problem.
What Is Gross Income?
For purposes of limiting home office deductions, gross income is income from the business activity conducted in the home office.
To calculate gross income, look to your profit reported on Schedule C if you are self-employed, or the portion of your salary earned in the home office if you are an employee. You can adjust your Schedule C profit for certain items. If you sold your home, the portion of the gain related to the home office increases your gross income for purposes of limiting home office deductions. If you suffer a loss on the home office portion, you reduce your gross income.
If your gross income from your home office business activity is less than your total business expenses, your home office deduction is limited. Your deduction for otherwise nondeductible expenses (such as utilities or depreciation) cannot exceed gross income from the business activity, reduced by the business portion of otherwise deductible expenses (such as home mortgage interest or real estate taxes) and business expenses not attributable to business use of the home (such as salaries or supplies). This sounds rather complicated, but Form 8829, Expenses for Business Use of Your Home, incorporates this limitation. This rule merely orders the categories of deductions.
If, after applying this ordering of deductions, you still have an unused home office deduction, you can carry forward the unused portion, provided you used the actual expense method; there is no carryforward under the safe harbor method. The carryforward can be deducted in a future year when there is gross income from the same home office activity to offset it. There is no time limit on the carryforward. You can claim it even though you no longer live in the home in which the deduction arose, as long as there is gross income from the same activity to offset the deduction. Be sure to keep adequate records to support your carryforward deduction.
Simplified Method
Instead of deducting the actual costs of the home that relate to the home office, you can rely on an IRS-created simplified method. This method lets you deduct up to $5 per square foot for up to 300 square feet for a home office. Thus, the maximum deduction is $1,500 ($5/sq. ft. × 300 sq. ft.). If the space you use for a home office is smaller than 300 square feet, your deduction will be less than $1,500. Figure the deduction for the simplified method using an IRS worksheet (see Figure 18.1). (The current worksheet is not available, but this older one can be used to figure the deduction under the simplified method for 2017.)
Figure 18.1 Simplified Method Worksheet for Home Office Deduction
To use the simplified method, the space must still meet the basic home office deduction rules (e.g., you use the space regularly and exclusively for business and the home office is your principal place of business or meets another home office deduction rule). If two people in the same home, such as spouses, each have a home office, each can use the safe harbor method as long as each office is a different portion of the home.
If the home office is used for only a portion of the year (e.g., the business starts in August or the business is seasonal), then you must make an allocation to determine the average monthly allowable square footage; more than 300 square feet may be taken into account for any one month. You are treated as having a qualified home office in a month only if the office is used as such for at least 15 days in that month.
The amount of the deduction cannot exceed the gross income limit (explained in connection with the actual expense method).
Depreciation. If the simplified method is used for a home office in a residence owned by you, no depreciation allowance can be claimed; depreciation for the year is deemed to be zero, and no basis adjustment to the home is required. If you use the actual expense method in a subsequent year, figure the depreciation deduction allowable in the subsequent year using the appropriate optional depreciation table applicable for the property, regardless of whether you used an optional depreciation table for the property in its placed-in-service year. Figure the allowable depreciation deduction for a subsequent year by multiplying the remaining adjusted depreciable basis allocable to the home office by the annual depreciation rate for the applicable year specified in the appropriate optional depreciation table. The applicable year is the year that corresponds with the current taxable year based on the placed-in-service year of the property.
Electing the simplified method. The election is made on a year-by-year basis. Making the election in 2017 does not bind you to using the safe harbor method in 2018. However, once you make the election, it is irrevocable and can be changed only with IRS approval.
The simplified method cannot be elected by an employee who is reimbursed for a home office for a period after use under a reimbursement or other expense allowance arrangement.
Special Business Uses of a Home
There are 2 exceptions to the exclusive use requirement: day-care facilities and storage space. If either of these exceptions apply, you can deduct your home office expenses even though the space is also used for personal purposes.
Day-Care Facilities
If you use all or part of your home on a regular basis as a facility to provide day-care services, you may claim home office deductions if you meet certain tests.
You must provide day care for children, elderly persons (age 65 and older), or persons who are physically or mentally unable to care for themselves.
You must have a license, certificate, registration, or other approval as a day-care center or family or group day-care home under your state law. You can claim home office expenses if you have applied for approval and are awaiting it. You cannot claim home office expenses if your application has been rejected or your approval revoked.
Note: Special rules for meal costs of day-care providers are covered in Chapter 22.
Calculating Your Home Office Deduction for Day-Care Services
If you use a portion of your home exclusively for day-care services (e.g., a basement playroom), you can deduct your expenses for any other type of business use of a home. If, however, you use a portion of your home for day-care services but also use it for personal purposes (e.g., your living room), you must follow special allocation rules to determine your home office deduction. You must compare the business use of the space with the total use of the space. There are 2 methods for making this comparison:
Compare the number of hours of business use in a week with the number of hours in a week (168 hours).
Compare the number of hours of business use in the tax year with the number of hours in a tax year (8,760 in a 365-day year).
Then this percentage is applied to the business percentage of total space.
If meals are provided as part of the day-care services, the cost of the meals is not included in a home office deduction. It is a separate expense. In calculating the deductible portion of the meal costs, 100% of the costs to day-care recipients is deductible (a standard meal allowance is explained in Chapter 22). If you also provide meals to employees, only 50% of the cost of meals for them is deductible. No percentage of the cost of meals consumed by you or your family is deductible. If you receive reimbursements under the Child and Adult Food Care Program under the U.S. Department of Agriculture, you must include in income any reimbursements in excess of your expenses for eligible care recipients.
Storage
If space is used on a regular basis for the storage of your inventory or sample products, you can deduct home office expenses even though you also use the space for personal purposes and thus fail the exclusive use test. The storage space that is deductible is only the actual space used. For example, if a portion of a basement is used for storage, only the expenses related to that portion are deductible even if the rest of the basement is not used for other purposes.
Expenses of storage space are deductible even though the exclusive use test is not satisfied if:
The home is the fixed location of the business activity (you run the business from home).
The business activity is selling goods wholesale or retail.
The space is used as a separately identifiable space suitable for storage.
Bed and Breakfasts
Typically, owners of a bed and breakfast live at their inn, using a portion of the premises as their personal residence. There is no exception to the exclusive use rule for bed and breakfasts as there is for day care and storage. The Tax Court has determined that no deduction can be taken for the portion of the inn used for both personal and business purposes (e.g., lobby, kitchen, and laundry room). A deduction is limited only to areas used exclusively for business (e.g., guest rooms).
Mobile Offices
Today, some small business owners use mobile offices to run their businesses. Instead of operating from a house or apartment, they operate from a recreational vehicle (RV). Here are some cases addressing the deductibility of mobile offices:
An orthopedic surgeon who parked his mobile home in the hospital driveway to be on call could deduct some costs of the vehicle, but not the 100% he had claimed.
A consultant who used his motor home for business could deduct interest on the loan to buy the home but not for travel in it; he lacked substantiation for business travel (see Chapter 8).
An insurance agent who took his RV to recreational vehicle rallies could not take a home office deduction because he used the RV for personal purposes more than 14 days of the year. Any personal use, including watching TV in the RV, makes the entire day a personal day.
Ancillary Benefits of Claiming Home Office Deductions
Claiming home office deductions means more, taxwise, than simply deducting the expenses related to that office. It means additional tax benefits may be available.
Having a home office means that travel to and from the office for business is fully deductible (there is no such thing as commuting from a home office). So travel from your home to a customer's location and back again is a fully deductible business expense. Business use of your car is explained in Chapter 9.
Having a home office also means it is not necessary to keep a log of computer use. A computer used in a regular business establishment is not treated as listed property for which an owner must prove business use exceeds 50% in order to claim first-year expensing or accelerated depreciation. A home office for which a deduction is allowed is treated as a regular business establishment. First-year expensing and depreciation are explained in Chapter 14.
Impact of Home Office Deductions on Home Sales
Claiming a home office deduction does not impact your ability to claim the home sale exclusion (up to $250,000 of gain; $500,000 on a joint return) if you otherwise qualify for it. In the past, it had been reasoned that gain on the portion of the home used as a home office would have to be reported. However, regulations make it clear that the exclusion can be applied to the home office portion as well, as long as the office is within the dwelling unit.
However, any depreciation taken on a home office for a period after May 6, 1997, must be recaptured at the rate of 25% (for taxpayers in tax brackets over this amount). This means you must report your total depreciation deductions related to home office use after this date and must pay tax on the total amount at the rate of 25%. You cannot use the exclusion to offset this tax.
You cannot avoid this recapture by choosing not to report depreciation to which you are entitled when you use the actual expense method to figure the home office deduction. Recapture applies to depreciation both allowed (the amount you actually claimed) and allowable (what you were entitled to claim). If you want to avoid depreciation recapture, you must sidestep the home office deduction entirely by disqualifying your home office or use the safe harbor method for the home office deduction. You can do this easily by not using the space exclusively for business. By disqualifying your home office, you lose out on depreciation but can still claim many related costs, such as office maintenance and utility costs, as ordinary and necessary business expenses.