Those deductions can add up, thereby lowering your taxable income and reducing the amount you owe Uncle Sam on April 15. Before you start spending that refund, however, there are a few rules you need to understand and heed. It’s a good idea to consult a tax advisor to be sure that you’re filing the right schedules and maximizing your deductions.
Passing the IRS litmus test
To meet IRS guidelines, your home office must be your principal place of business, or the place you see clients in the normal course of business. Parts of your home you use to store products or equipment for your business also count. That doesn’t mean that all your work has to be done from home. If you’re an outside salesperson, you probably spend most of your work time elsewhere. But if you do you billing and return customer calls primarily from your home, your home office should qualify.
You can also qualify for the deduction if your employer requires you to work from home, as long as you don’t charge your employer rent. One big catch is that you can’t deduct expenses for your home office if you choose to work at home even though your employer provides you with an office. IRS Form 8829 can be used by self-employed workers to calculate the home office deduction, which should be reported on Schedule C.
Measuring your home office
The amount you can deduct for your home office depends on the percentage of your home used for business. Your work space doesn’t need to be a separate room—a table in a corner qualifies. But it has to be an area that’s used solely for business. The tax break also covers separate structures on your property, like a detached garage you’ve converted to an office. Unlike an office inside your home, a separate structure doesn’t have to be your main place of business to qualify for a deduction. That’s because the IRS believes your family is less likely to use a separate structure as a part-time play area or den, says Mark Luscombe, principal analyst for tax and consulting at CCH.
To calculate what percentage of your house the home office occupies, divide your home office’s square footage by the total square footage of your home. If your home is 3,000 square feet and your office is 150 square feet, for example, you’d use 5% to calculate your deductions. Not sure how big your house is? Check the documents you received when you bought your home—there’s probably a detailed rendering—or measure the outside of your home and multiply length times width.
What can you deduct?
Once you’ve figured out what percentage of your home you use for business, you can apply that percentage to different home expenses. These include:
- Mortgage interest
- Real estate taxes
- Utilities (heating, cooling, lights)
- Home repairs and maintenance (painting, cleaning service)
- Homeowners insurance premiums
Just take each expense and multiply it by your home office percentage (the 5% mentioned above). That’s the amount you can deduct as a business expense. So if you spend $150 a month on electricity, you can deduct $7.50 as a business expense. That adds up to a $90 deduction per tax year. If your annual business expenses total $10,000, your deduction is $500. In 2009, lowering your taxable income by $500 to $99,500 would’ve cut your tax bill by $113.
Save bills or cancelled checks to prove what you spent in case of an IRS audit. Take an hour a week to file them away. Also, only repairs can be expensed; improvements must be depreciated. One catch: You can only deduct expenses if your business generates income. Expense deductions are limited if they exceed your gross business income, says Mark Steber, chief tax officer at Jackson Hewitt Tax Service.
Don’t forget depreciation
Depreciation is based on the idea that everything—even something like a home—wears out eventually. To figure home office depreciation, start by calculating the tax basis of your home: generally the purchase price plus the cost of improvements, minus the value of the land it sits on. Next, multiply the tax basis by the percentage of your home used for work. This gives you the tax basis for you home office. Finally, multiply that by a depreciation percentage that’s set periodically by the IRS. There are caveats. For a crash course, read IRS Publication 946 or talk to a tax professional.
One reason to think twice before taking depreciation on your home office is that it reduces the capital gains deduction you can get when you sell a home. If you’ve deducted depreciation, you have reduced your capital gains exemption ($250,000 of profit if you’re a single filer, $500,000 for joint filers) by the depreciated amount. That could mean you’ll owe taxes when you sell, especially if you’ve lived in your home for a while.
This article provides general information about tax laws and consequences, but is not intended to be relied upon by readers as tax or legal advice applicable to particular transactions or circumstances. Readers should consult a tax professional for such advice, and are reminded that tax laws may vary by jurisdiction.
By Donna Rivera for HouseLogic.com September 2009
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