The home office tax deduction can be tricky question and there is no short explanation. When you have your own business, there are many deductions that are cut and dry. This one is not. And there’s an IRS take back on this one if you use the original method. Most taxpayers are unaware of this, and it can cost quite a bit in future taxes. Please note that this applies to homeowners. Tenants need not be concerned about the issue emphasized here.
Who Qualifies for Home Office Deduction
Some people have one room in their home that is exclusively used for their business. Their computer in that room is used exclusively for business. There is no bed, closet or television that can be considered personal use items. This describes those who either meet with clients in other places, or now with the new technology, over the internet via Skype type programs or over the phone.
Other people have a true office set up, like when an accountant or attorney uses part of his home for an office that clients visit. There is a room or group of rooms in a portion of the home that has a separate entrance. All business equipment is in that area and clients are seen there for the services. In this case, a home office deduction is viable, even though it is subject to the same rules as the previous scenario.
The Mandatory Deduction for Home Office Deduction Users
When you use the Regular Method take the home office deduction, it’s not just a percentage of your household expenses. You also use a percentage of your home and you must depreciate it. For many, that’s a scary term. It’s a subject that baffles many new tax preparers for some reason also.
For those of us who know the IRS very well, here is a slogan that applies to depreciation in addition to other business issues. “What the IRS giveth, the IRS taketh back.”
Before I get into the depreciation “take back” I want to give you the elementary school version of what it actually is. I don’t know why the IRS can’t explain it this way. I guess they would have to reduce the size of their audit department… but I digress.
Sample Home Office Deduction Case
Here’s an example of how depreciation is calculated, in really basic terms, with simplified numbers, just so it’s easier to follow.
You purchase a home for $390,000. Yes, it’s a McMansion… You use 1 room exclusively for business, so that’s 10%. So 10% of $390,000 is $39,000.
$390,000 x 10% = $39,000
Next IRS determines the useful life of the structure, and for 2016 that’s 39 years (as per the IRS Chart) Dividing $39,000 by 39 years would give you a $1,000 deduction per year. (IRS may or may not divide these evenly, but we are doing it here, just for purposes of this example.)
So this is great, or so you think! You get a $1,000 dollar deduction for depreciation every year.
Future Implications of the Home Office Deduction
20 years later you’re ready to sell your house, downsize and retire. Profit on the sale of a personal residence is not subject to taxes using the one time exclusion as long as your profits don’t exceed $500,000 if married filing jointly or $250,000 if you’re single. So the sales price would have to be more than $640,000 for a single person to even begin to make any tax calculations.
BUT you converted 10% of your home to “business property” so only 90% of the figures above are relevant. But don’t worry about THOSE numbers. This is the point…
You have deducted $20,000 in depreciation on your home. And now it’s time for the IRS to “take it back”. They call it Depreciation Recapture. Without getting into the details of which complex forms you need to use and how much time and cost in accounting fees, understand this. You need to add back this $20,000 to your income, and it’s subject to capital gains tax. While the capital gains tax is lower than the ordinary income tax rate RIGHT NOW, there is no way to predict what it could cost you in the future.
NEW OPTION IN 2013 – Home Office Deduction Simplified
Want to sidestep all this mind boggling calculation and potential capital gains taxes? If you’re self-employed the IRS is actually throwing you a bone.
In 2013 the IRS came up with an alternate that they named the Simplified Method. If you qualify, you may use a flat rate of $5 per square foot, limited to 300 square feet. That’s a $1,500 maximum deduction for the year. This replaces the percentage of household expenses such as mortgage, property taxes and utilities. It also relieves the burden of keeping all those records. The bonus is that there is no depreciation involved, so when you sell your home, there are no adjustments or capital gains taxes. If these details intrigue you, feel free to read the IRS publication.
You can flip flop back and forth between the Regular and Simplified methods, but in that case you must do the depreciation dance.
Recap of the Home Office Deduction
If you have a true home office where you see clients, the Regular Method home office deduction should be taken, and the back end taxes will be worthwhile in the long run.
If you have a cyber office and use one room for your business in your home, the Simplified Method should be your best choice.
These rules are for self-employed taxpayers. While some tax practitioners prepare Home Office deductions for employees who do work at home, that could be the equivalent of waving a red flag at the IRS to come and audit you.
This deduction for employees is for those whose employers require them to work out of their home. There are stringent requirements. In some cases it’s a valid deduction and might need to be explained to the IRS…
Most of my clients would rather stay off their radar, and use the Simplified option.
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1 thought on “Self-Employed Home Office Tax Deduction”
Very nice post, Ellen! Interesting to read, and educational too. I didn’t know of the Simplified Method of deducting a home office.