Last year, many of us were required to turn our living rooms, bedrooms, and other personal spaces into home offices. This raises a potential question in the minds of taxpayers; is it possible to receive deductions for our temporary office headquarters?
When conducting business out of one’s home, taxpayers can deduct certain expenses related exclusively to their trade or business. Initially, all employees could take advantage of the home office deduction. However, in 2017 the Tax Cuts and Jobs Act (TCJA) was signed and altered the guidelines to allow only self-employed taxpayers or shareholders of corporations or partners in partnerships to receive the deduction. Therefore, if you are self-employed, or are a shareholder or a partner, and work from home, you could qualify for the deduction.
In the eyes of the IRS, your home office must meet their “exclusive and regular use” requirements. The space you are using for business must be used exclusively for business. An example is if your space is used for both business and creating artwork, this will make your space ineligible for the deduction. While your home office doesn’t have to be the only place you meet clients or have meetings, it must be the principal place of business. If you have a home office and an additional office elsewhere, your space will be ineligible.
Business Use of Home
Once you determine you qualify for the deduction, the next step is deciding whether to use your actual expenses for the deduction or to utilize the simplified method. Let us explain.
Actual Expenses
Using this method requires you to maintain strict records and keep receipts of all your expenditures. You’ll also need to calculate the percentage of your home that is your dedicated home office. To do so, you’ll take the overall square footage of your home, and divide it by the square footage of your home office space. For example, if your home is 2000 square feet, and your office space is 200 square feet, then your home office encompasses 10% of your home. If you store inventory in your home, you can also include the storage area into your calculation only if it is exclusively used for business purposes. Next, you’ll need to examine your expenses related directly and indirectly to your business.
What’s the difference, you ask?
Direct Expenses are those expenses paid only for the business part of your home. For example, direct expenses could be repairs made directly to your home office area.
Indirect expenses are expenses for the general upkeep of your home as a home.
For example, mortgage interest, homeowners’ insurance, utilities, property taxes, depreciation, and even rent. Using the example from above, if your home office is 10% of your home, you may be eligible to deduct 10% of these indirect expenses as a home office deduction.
Please note that this deduction cannot exceed your net income. If your deduction is not 100% utilized, it will be carried to the next year. In the event you choose to depreciate your home you will be subject to recapture which will occur if you decide to sale your home. The IRS applies recapture to prevent taxpayers from receiving double benefits. Currently, taxpayers can exclude up to $250,000 for single filing taxpayers or $500,000 for married filing taxpayers on profits gained from selling their residence. Any profit related to your depreciation deduction will be forfeited from this exclusion and will be taxed as a capital gain.
Simplified Method
What if you don’t have time to keep up with your business-related expense receipts or you just don’t want to keep track? That’s where the simplified method comes in. This method eliminates those burdens. When utilizing this method, taxpayers would take the tax year’s prescribed rate multiplied to the allowable square footage of their home office. For the 2020 tax year, the IRS allows $5.00 per square foot of the home office up to 300 square feet. So, if your office is 200 square feet, like our example above, you would multiply 100 by $5.00, arriving at a total deduction of $1,000. Note: You must choose between using actual expenses or the simplified method. You cannot utilize both. It is also important to note, the deduction from the simplified method cannot exceed the net income of the business. Using this method also denies you the ability to carry over any loss you do not fully utilize. This means, one cannot create a business loss. As this method doesn’t consider any actual expenses, there is no need to worry about depreciation recapture in the event you sell your home.
It’s currently tax season. Once you’ve gathered your tax documents, talk to your trusted tax advisor about whether you qualify for this deduction. If you need a trusted advisor, you can make an appointment with us online today.
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