Tax Strategies & Credits

How to Avoid Pitfalls with the Home Office Deduction

How to Avoid Pitfalls with the Home Office Deduction

Note: The tax filing and payment deadline for 2019 tax returns has been delayed from April 15, 2020 to July 15, 2020.

In addition to more employees becoming remote than ever, home-based businesses make up the majority of U.S.-based small businesses. About 15 million small businesses are home-based, and this number is expected to continue rising since the digital age makes entrepreneurship easier and more accessible than ever. The self-employed enjoy many personal and business benefits of working at home or having the option to take a laptop anywhere that has internet.

However, the IRS allows a fairly generous deduction for using a portion of your home for work. While you are legally entitled to take advantage of this if you have a home-based small business, there are certain rules to bear in mind. The home office deduction tends to be a popular audit target since there are several items prone to overstatement, namely the size of the space used for work and whether it is exclusively used for business.

Here’s what you need to be aware of when taking the home office deduction.

1. There is a “regular and exclusive” element you need to prove.

The landmark case Soliman v. Commissioner was the ultimate decider that self-employed people can deduct home office expenses if none of their clients provide them with a place to work, and they are not paying for workspace themselves. In short, Soliman was a self-employed anesthesiologist. While his focal point was caring for patients at the hospitals, he used a spare bedroom in his home to store and prepare treatments, do medical research, bill providers, and contact doctors, insurers, and patients. None of the hospitals gave him an office to perform these tasks, and he kept them confined to this one room at home.

You must have an area of your home that you use regularly because space is not furnished to you. As for the exclusivity portion, this also means that your family can’t use the area for personal use (such as your children having a quiet place to do their homework). The occasional coffee shop trip won’t hurt your deduction, but if you regularly use co-working spaces and similar day office services, it could affect your deduction based on lack of regular and exclusive use. It raises red flags if the IRS sees both the home office deduction and your space rental reported on the same tax return.

2. Take care to separate direct from indirect expenses.

Generally, you calculate a business percentage based on the total square footage or number of rooms in your home (or separate structure on your property) and use it against your total expenses.

You may miss out on significant tax savings by not separating direct from indirect expenses. Indirect expenses apply to your whole home, including rent or mortgage payments, insurance and utilities, and must have the business percentage applied. Direct expenses apply to your home office only, such as cleaning or painting the room, and 100 percent of these expenses can be deducted.

3. Homeowners have several additional boons, but also extra pitfalls if they plan to sell the home soon.

Renters have more a more straightforward computation for the home office deduction, since they only need to calculate a percentage of the rent. Homeowners get far more deductions because of prorated mortgage interest, property taxes, and an allowance for depreciation of the cost of the portion of the home used for business net of land costs.

These deductions can save thousands of dollars in taxes over the years, but it can also put the homeowner in for a rude awakening when they decide to sell since homeowners can generally exclude up to $250,000 ($500,000 for married taxpayers filing jointly) of home gain. However, any gain attributable to depreciation cannot be excluded. In addition, if the home office was in a separate structure, the home sale would have to be allocated between the home and the separate structure, and no gain attributable to the separate structure can be excluded under the home sale rules.  

While this doesn’t stop people from claiming the home office deduction, it’s important to keep in mind if your home has dramatically appreciated in value.

4. The simplified deduction only saves you a calculation, not the burden of proof that you exclusively use your home for business.

The traditional home office deduction relies on calculating the business percentage of your home-related expenses and taking 100 percent of indirect expenses. The simplified version relieves you from having to track down these receipts; just use $5 per square foot, up to 300 square feet for a maximum deduction of $1,500.

While this is often far less than the traditional deduction, it relieves homeowners from the depreciation recapture tax. However, you have to prove the same regular and exclusive use, so you might as well take the bigger deduction for the same documentation efforts.

5. You don’t actually have to claim an entire room for the home office deduction.

Small living spaces can make personal and business areas encroach on one another by default. But even if you just lay down some electrical tape to cordon off a work area or use a closet, provided that you can prove regular and exclusive use, and thoroughly document the expenses, you should have no trouble defending your home office deduction.

Jon Osborn, EA writes for TaxBuzz, a tax news and advice website. Reach his office at [email protected].   

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Steward Financial

Steward Financial

Jon Osborn is a tax preparer based in San Dimas, California. His company, Steward Financial Services, offers a broad range of tax preparation, accounting and business consulting for small businesses. He loves to work with clients who are looking for answers to complex tax and business planning issues. He has owned several small businesses and worked with over one hundred small business owners. He helps his individual and business tax clients find the best ways to spend their money in order to minimize IRS tax. Small businesses looking to grow, sell or just increase cash flow are one of Jon's specialties.

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