If you are a small business owner or you’re self-employed and work from home, you will likely be able to take advantage of the home office deduction in 2020. According to the IRS, small business owners are leaving money on the table each time they file their taxes. Of the 23.4 million returns filed by sole proprietors for tax year 2011 (the latest year for which statistics are available), 7.6 million filers claimed a home office deduction.
This works out to only 32% of eligible filers, way fewer than the 52% of small businesses that operate from home.
Home office deductions are one of the most commonly missed expenses that merchants aren’t taking advantage of on their tax returns. This is due to some misconceptions about what qualifies as a home office deduction, as well as some confusion around how to calculate the total expense you wish to deduct. Start with this guide to learn more about home office deductions for small businesses, and for extra assistance, get in touch with our experts.
What qualifies as a home office deduction?
The IRS allows small businesses to take a home office deduction whether you own your home or just rent it. The deduction is available for all types of homes – from a houseboat to a studio apartment – but not a hotel room or temporary lodging. There are a few conditions you must meet in order to take this deduction.
- Regular and exclusive use: the space you use as your office must be used exclusively for conducting business. For example, if you’re using a spare bedroom as both your office and a children’s nursery, that room is ineligible for this deduction.
- Principal place of business: your home office must be your primary place of business, meaning you use the space “exclusively and regularly for administrative or management activities.” Activities that qualify include things like billing customers, bookkeeping, and setting up appointments.
If you meet these two conditions, then the next step is to calculate how much you can claim against the home office deduction on your tax return.
Actual expense method and simplified expense method
There are two ways to calculate the value of your home office deduction: the actual expense method, which is more complex, and the simplified expense method.
The actual expenses method, or regular method considers any direct expenses that you incur in full, as well as a percentage of your indirect expenses – things like insurance, utilities, real estate taxes, and more. This calculation requires the percentage of your home that’s dedicated to business activities. Then, certain expenses can be claimed as a percentage, like mortgage interest, or insurance premiums.
The simplified expense method can be used if your home office is 300 square feet or less. In this approach, the square footage of your space is multiplied by a prescribed rate of $5/square foot. Here, you aren’t deducting actual expenses, making the calculation much more straightforward. For example, if your office space is 100 square feet, you can deduct $500 from your tax return
The method you use to calculate your deduction depends on the size of your space and your record-keeping ability. If you have a good record of indirect expenses going into your home, it might be worthwhile to do the actual expenses calculation. Our experts can help you make that decision.
Home office expenses for renters vs. homeowners
You don’t need to own your home to take advantage of the home office deduction. However, you do need to be savvy about what you can claim under the actual expense accounting method. Direct and indirect expenses vary depending on whether you’re renting or a homeowner.
Home office qualifying expenses for homeowners might include mortgage interest and real estate taxes. Likewise, indirect expenses include things like utilities, repairs and maintenance, casualty losses, and depreciation. These expenses are things that both renters and homeowners can take advantage of.
For renters, payments to your landlord qualify under this deduction, as long as you’re adhering to the “regular and exclusive use” and “principal place of business” stipulations. Deduct a percentage of your rent equal to the percentage of your home that is devoted to your home office and business activities. You can also include things like “renters’ insurance, electricity, security systems, heating and cooling systems…internet and a secondary phone.”
How moving affects the home office deduction
What happens when you move residences during the tax year?
First, there are some business moving expenses that you can deduct. These are categorized under two broad allocations: the actual move itself, and the move to a new home that directly impacts the move of the business.
Under the first category, business moving expenses, you can deduct the cost of moving inventory such as supplies and equipment from one location to another. If you have a new lease or mortgage payment, this also qualifies as a deductible cost.
When the move is directly related to starting a new business or if you’re self-employed, there are some personal moving expenses you can also claim under IRS guidelines. Personal moving expenses must be “directly related” to the business move and meet these two qualifications:
- The distance test: the IRS says, “your new main job location [must be] at least 50 miles farther from your former home than your old main job location was from your former home.”
- The time test: for self-employed business owners, you must work full-time for 39 weeks during the first 12 months, and at least 78 weeks during the first 24 months to deduct personal move expenses. If you’re a full-time employee, the IRS defers to industry standards to determine if you meet the time test requirement.
Moving expense deductions don’t impact your home office deduction, but they can be used in tandem. When claiming your home office expenses, perform the calculation for each space separately and then add them together for a cumulative home office expense over 12 months. Speak with one of our CPA experts for assistance in this calculation.
Gross income limitation and carryover benefits
In some instances, the IRS may limit how much you can claim under the home office deduction. When your gross business income is less than your home office expenses, the IRS allows you to carry over the remaining deductions to the next tax year. These expenses will be subject to next year’s deduction limit.
Here’s an example of how this works. Pretend your Gross Business Income is $10,000. Your total home office expenses are $12,000. In this example, you are subject to the deduction limit because your expenses exceed your income.
|Gross Business Income:
|Home Expenses (Real estate taxes, etc.) 10%:
|Business Activity Expenses (Second phone line, etc.) 100%:
|In this scenario, your deduction limit is $2,000. However, you still have $4,000 in-home office expenses that you may wish to deduct. You will have to carry over $2,000 to the next tax year.
|Additional Home Office Business Expenses (Utilities, etc.) 10%:
($2,200 allowable, but can only deduct $200 this tax year
because of the deduction limit)
|Depreciation Carryover to the Following Tax Year ($2,200-$200):
If you’re worried you might meet the gross income limitation, first calculate the percentage of your home that you will claim against the home office deduction. For example, if you have five rooms in your house and you use one room as your office, you will claim a 20% deduction.
Apply the percentage (in this example, 20%) to your indirect expenses, such as mortgage interest, real estate taxes, or utilities. Then, calculate your total direct expenses, such as office supplies and a phone line dedicated to your business. You can deduct 100% of these expenses. Add this total to the indirect costs. This is your deduction limit.
Then find your business’s gross income for the year. If your expenses are less than your deduction limit, you’ll be eligible for the home office deduction.
Work with a CPA to make sure you’re taking full advantage of the deductions available to your small business. Get in touch with cpaservices.com to get started.
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