7 Home Office Tax Deduction Considerations
I’m going to try something new here, and we’ll see how it turns out. The thing is that I’m weirdly passionate about taxes, but find that others just want to tuck the information into their back pocket for April 15th.
So, in order to both have a good backlog of tax stuff AND to not focus solely on that, I’m going to see about having a weekly Tax Tuesday (because alliteration, of course).
Let’s dive in.
For freelancers, independent contractors, entrepreneurs, and so many more thanks to COVID, work starts and ends at home. There is no office to drive to or separate location where you work. It’s all in that basement space or extra room where you can get some piece and quiet and churn out work.
The question, then, is if others get to deduct their separate office or retail space, can you deduct your home office?
I mean, you’re already paying for the space, might as well let it offset some of your tax liability, right?
To only slightly change the cliché, the IRS (which, no, is NOT the devil) is in the details. Let’s discuss the top 7 things to consider before you count on taking the home office tax deduction.
1. The Home Office Tax Deduction is NOT for Employees
Let’s get this out of the way first: if you’re an employee, you’re not getting a deduction (if you are an S Corp owner/employee, see point #7).
So, no, just because COVID has created a new world with more people working from home, you do NOT get a deduction for your home office. Or that desk you bought for it. Or that nice swivel chair.
And so on.
This is actually a relatively new phenomenon, changed by the 2017 TCJA tax reform. For all those employees COVID switched to working from home, this tax change couldn’t have come at a worse time.
2. Your Office Must be a Dedicated Space
One of the sticky points for the home office tax deduction is that the area must be SOLELY used for your business.
SOLEY. Got that? Need it in bold?
Now that I’ve delivered the bad news, let’s get some good news. An office doesn’t need to be an entire room. You don’t even need walls (though the IRS does like them).
EXAMPLE TIME: Anna decides she really wants this deduction, so she decides that the bedroom computer will be just for business, not for late night sessions of Monster Train. She measures out 75 square feet of her bedroom and declares that is a business-only zone.
Can Anna take the home office tax deduction?
Yes! Yes she can!
Even better, she can even use that area for other purposes incidentally, so just walking through it to go to the bathroom won’t screw up her deduction.
Also, there’s special rules for storage and day care facilities that allow the space to not be dedicated. If that sounds like you, let me know and I can make it a topic of another Tax Tuesday.
3. Depreciation On Your House
Now you have a dedicated office space. What’s next?
(If you’re renting your place, go ahead and skip this part)
For those saner, non-accountant people out there, depreciation is when you take something expensive that will last you a long time and account for the wear and tear per year.
Normal people may run into depreciation when they try to make an insurance claim on their roof for hail damage and the insurer doesn’t pay the full value of a new roof because of depreciation (speaking from personal experience).
Let me try to explain it with a couple of examples.
EXAMPLE TIME: Sandra buys a house for $200,000. Her (completely valid and deductible) home office takes up 10% of the house. She will eventually get to take a $20,000 deduction on the home ($200,000 x 10%), but since this is depreciated, she’ll only get to take a small portion of that per year.
Here’s a chart showing the depreciation percentages. Explaining it is a whole topic by itself. Again, if you’re interested, let me know and we’ll do another Tax Tuesday.
But, just to give you an idea of the deduction here, Sandra would be able to expense $727 in a normal year ($200,000 x 10% x 3.636%)
That might not be much of a deduction, but it’s something. The bad news is that it reduces the basis of your home, which will increase your gain when you sell it.
EXAMPLE TIME: Sandra lives in her house for a really long time, getting to take that full $20,000 deduction. She then goes to sell her house for $300,000.
Had she not taken depreciation, she would have recognized a $100,000 gain. But since she did take depreciation, her gain will be $120,000.
Note that whether or not you’ll actually recognize a gain when you sell your house depends on a host other issues (taxes are complicated). Assuming you do, this then becomes a trade off between lower taxes now and potentially higher taxes later.
Which, if you ask some financial guru about the Time Value of Money, will likely tell you this is a good trade off…assuming you can get your other tax facts lined up right.
4. Claim All Your Direct & Indirect Expenses
The home office tax deduction is broken down into two buckets of expenses: direct and indirect.
Direct expenses are payments directly related to the office. Is there a hole in your office drywall from some indoor golf? Repairing it is specifically for the office, so it’s a direct expense.
Other common direct expenses would be paint, carpeting, and windows. Anything that’s actually attached to the home.
These direct expenses are fully expensed right now as part of the home office deduction.
Indirect expenses would be for things like rent or mortgage payments, insurance, and property taxes. Things that you’re paying for the whole house but that a portion could be allocated to your home office.
When you’re determining how much to deduct, think about everything you put specifically into the office, then think about everything you spent on your house and whether any of that could be appropriately allocated to your office.
A new roof? Yeah, that could potentially be an indirect expense. A new front door that goes into a non-office room? That’s not going to be either direct or indirect.
5. Don’t Forget Utilities!
One very common indirect home office tax deduction is your utilities.
You use gas to heat that office, electricity to make the lights work, and potentially even water. You’ll pay these for your whole house. Make sure to track these through the year and include them as an indirect home office tax deduction (as appropriate).
NOTE: Some people now consider internet a utility. That’s not included here. That would be deducted as a non-office related business expense elsewhere.
6. The Simplified Method Can Save a Lot of Headaches
Want to avoid dealing with depreciation? Don’t have time to calculate your utilities?
Then save time with the Simplified Method for the home office tax deduction!
Unlike some of the things the IRS deems as simple, this method really is. You get a $5 deduction per square foot of dedicated office space, up to 300 square feet (so $1,500 a year).
No tracking, no extra math. Just your square footage multiplied by $5 and you’re done.
EXAMPLE TIME: Anna has that 75 square foot area for her music recording business. If she took the simplified method, she could deduct $375 a year.
7. S Corps Can Take This Deduction, Too…If You Set It Up Right
Have you gotten all complicated with your business because someone convinced you that you could save money if you have an S Corporation?
Then I have a bit of bad news. If you’ve set up an S Corp, then you’re technically an employee, which pushes you back to point #1.
Fortunately, with some creativity, you can still take the deduction.
I’m not talking about anything questionable, either. If an employee is working from home and their company reimburses them to set up a home office, the company gets that deduction (most likely…again, taxes are complicated). You’re just trying to do the same thing for you and your company.
That means you’ll want to set up your business (the S Corp) to reimburse you (the employee) for your home office expense.
You’ll have to be a bit careful here. There’s no specific IRS rules, no helpful IRS guidelines on do’s and don’ts. Instead, you have to determine if your expense is normal and reasonable for your kind of work.
Like everything with taxes, I would strong recommend talking with a tax professional about your specific tax situation before you go down this path. Just to make sure you’re keeping it all above board.
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