2020 has been a unique year to say the least. Many people who would otherwise commute to an office or jobsite every day are finding that they need to work from home because of the COVID-19 pandemic and social distancing restrictions.
There may be tax benefits for individuals who find themselves setting up shop at home for an undetermined period of time. Here’s what you need to know to take advantage of those rules.
Home Office Defined
The IRS allows taxpayers to deduct, in certain circumstances, a portion of the costs used to maintain a home office. To start the evaluation of whether you qualify to take a home office deduction, you must have a business. This may be a business where you are self-employed or where you’re a partner in a partnership. Employees are not eligible to take a home office deduction for the portion of their home used in that employment.
Next, you must identify an area of your residence used for this business. Your residence can be a house, apartment, condominium or similar property in which you conduct business activities. Generally, this is a separate room or floor of your home that is used for work. This space generally cannot be available for recreation or other non-business activities. Many people working from home will set up a computer in a dining room or spare bedroom, but that space is also used for non-business activities like eating, storing household items or watching television. These non-business activities would disqualify a taxpayer from taking the home office deduction for that space.
The next hoop you must jump through to take a home office deduction is that the space must be used exclusively on a regular basis as:
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The principal place of business for any of your trades or businesses,
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A place of business used by your patients, clients or customers to meet or deal with you in the normal course of your trade or business, or
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In connection with your trade or business if it is a separate structure not attached to your home.
This space may be used for administrative activities in your business. If you use a portion of your home to store inventory or product samples, you may qualify for the deduction if you meet all of the above criteria and, in addition, there is no other fixed location for your business. If you operate a daycare facility from your home, you may be able to get around the “exclusive use” criterion if you have been granted a license or other approval as a daycare center under state law. Home office deductions for daycare facilities are more complex and outside the scope of this article, but may be found in IRS Publication 587, “Business Use of Your Home.”
Home Office Deduction Calculation
There are two methods available to calculate your home office deduction: a simplified method and a standard method. Both methods require that you first measure the home office area in square feet. Your home office area does not need to be partitioned-off from other areas of your home by a wall or other barrier.
The simplified method is available for tax years beginning on or after January 1, 2013. The simplified method allows you to deduct $5 per square foot of home used as a home office. This deduction is limited to $1,500 per year. If you elect to use the simplified method by claiming the deduction, you do not deduct any depreciation on your home. You may switch between using the simplified and standard methods each year, but the election to use the simplified method is irrevocable for the year you make it.
The standard method is slightly more complex. Using the area of your home office, you will need to calculate the ratio of the area of your home office to the area of your home. For instance, if your home office is 200 square feet and your entire home is 4,000 square feet, your home office ratio will be 5%.
Next, you will classify the costs to operate your home office as either direct or indirect. Direct expenses are costs used exclusively for your home office and would include a dedicated phone line and repairs to the home office space. These costs are 100% included in your home office deduction. Indirect expenses are costs used to maintain your entire home and are allocated between the business use and personal use of your home using the ratio calculated previously. Only the portion of those costs allocable to the home office are deductible. Typical examples of these costs are insurance, mortgage interest, rent and utilities.
You may also include an expense for depreciation on your home office. Conceptually, depreciation expense is a reduction in the value of property, in this case your home, as it is utilized in your business. It is not an expense that is paid in cash and is why depreciation is referred to as a “non-cash expense.” The allowable depreciation expense is based on the “depreciable basis” of your home. Depreciable basis is calculated by multiplying the ratio of the home office area calculated earlier by the smaller of (a) the adjusted basis of your home (excluding land), or (b) the fair market value of your home (excluding land) on the date you began using your home for business. Each year, you will multiply your depreciable basis by a MACRS Percentage factor for 39-year nonresidential real property to obtain the amount of depreciation you can take. Bear in mind that if you sell your home, any depreciation you have taken on it will need to be incorporated in the calculation of gain if you sell the home for more than its basis.
Finally, the amount of your home office deduction will be limited if you have a net loss from your business. Any amount disallowed as a home office deduction may be carried forward to future years.
Where to Deduct Home Office Expenses
If you itemize deductions, you’re already getting a benefit from mortgage interest and real estate taxes on Schedule A. If you take the home office deduction, the portion of each allocable to your business will be captured in your home office deduction and ultimately moved to Schedule C or Schedule E. The non-business portion will continue to be part of your itemized deductions. If you are taking the standard deduction, you can still calculate your home office deduction using the standard method. All of these calculations are generally performed on Form 8829 and then carried over to Schedule C, Schedule E or Schedule F.
If you elect the simplified method, you can do the calculations directly on Schedule C.
Need Help?
The home office deduction can help lower your taxes without much additional out-of-pocket cost if you’re working from home and meet the right qualifications. If you have questions, contact us here or call 800.899.4623.
