Once you've determined that you qualify for the home office deduction, you can determine the amount based upon the portion of your home used, the length time used and your expenses.
The qualification requirements for the home office deduction state that a portion of your residence be used regularly and exclusively for business purposes. But, this space need not actually be an "office." It can be a conference room, a lab area, storage room, or some other type of business usage. If you do have an area that you use regularly and exclusively for business, the tax law permits you to deduct a portion of certain expenses relating to your home.
If you pass the qualification tests, which means you have a home office, the next step is determining the amount of your deduction.
This is a multistage process. First, you must determine which expenses are deductible. Then, you must calculate:
- the "business use" portion of your home and
- the length of time your home was used for business during the year.
When you complete these calculations, you are ready to apply them to determine the amount of deductible expenses that you can claim. Although calculating the home office deduction depends on a surprisingly large number of factors, don't be alarmed - we'll explain them all to you.
Beginning in 2013, you may be able to use a simplified method to determine the amount of your home office deduction. The qualification rules (regular and exclusive use) remain unchanged, but many people will be able to reduce the computation to a few easy steps.
What expenses are deductible?
Deductible home office expenses generally fall into one of two categories:
- Direct costs. These are expenses that benefit only your home office. An example of a direct cost would be redecorating the room used as your office.
- Indirect costs. Indirect expenses are expenses that you'd have to incur even if you didn't have an office in your home. The obvious examples are mortgage payments, rent, and utilities.
Tip: Remember, even if you don't qualify for a home office deduction, you are still entitled to claim all of your business expenses not tied to the business use of your home on your Schedule C. This means you can claim a deduction for office supplies or for office equipment--even if you do not claim the home office deduction.
Two methods available to determine business portion of home
For most types of home office expenses, the amount you may deduct depends primarily on the percentage of the space in the residence that is used for business.
There are two common ways to the business portion of your home:
- number of rooms, or
- square footage.
The first method (number of rooms) looks at the number of rooms used for business, divided by the total number of rooms in your house.
The second method looks at the square footage of the space used for business, divided by the total square footage of the house. Most of your home expenses (such as rent or real estate taxes and mortgage interest) must be multiplied by the larger of these two fractions to determine the portion that's deductible as a home office.
The tax laws allow you to use whichever method results in the larger deduction--so make sure that you calculate your deduction using both methods.
For example, if you have an eight-room house and use one room as an office, your business use percentage will be 1/8 or 12.5 percent. Alternately, if your home office was 168 square feet and your home was a total of 2000 square feet, your business use percentage will be 168/2000 or 8.4 percent. In this case, you will have a larger deduction if you use the "number of rooms" calculation.
Day care providers can use "time" method. The IRS provides a special tax break for home day care operators. These business owners can count all the space they regularly use for their day care business as the "business portion of the home" even though the same space is used for personal or family purposes.
For example, they may include the bathroom, the kitchen where day care meals are prepared, and the family bedrooms where naps are taken. However, unlike most home business operators, they must prorate these expenses for the hours in which the day care is offered.
Calculating partial year home office deduction
Most people do not start up a new business precisely on January 1. Most likely, you opened your business at some point after January 1 and before December 31, and your first year in the home office was not a complete one. Similarly, people who close down their business don't always do it precisely on the last day of their tax year.
As a result, for the first year in which you began using your home office, and the year in which you closed your business, you'll have to prorate your home office expenses based on the percentage of the time your home office was actually used.
Example: If you began using your home office on July 1 of this year and continued to use it through the end of the year, you can use only your expenses for the last half of the year in computing your home office deduction.
Special rules apply to depreciation. The IRS provides a table showing the fraction of your depreciable basis that you can deduct for the first year of use, based upon the month in which you started using the office.
For the last year, you'll need to determine the amount of depreciation you'd normally deduct for the year, under the usual rules. Then, you multiply this amount by a fraction: the numerator will be the number of months that you used the office, and the denominator will be 12. Count the month in which you stopped using the property as half a month. For example, if you stopped using your office in October, the fraction will be 9.5/12.
Special rules apply to home day care operators. The IRS provides a special tax break for home day care operators: they can count as "business use space" whatever portion of the home is regularly used for day care purposes, even if the same space is also used for personal living purposes. However, they must prorate their home office expenses based on their hours of operation.
Example: A home day care operator's expenses for mortgage interest, real estate taxes, depreciation, utilities, and property insurance amounts to $10,000. She estimates that 80 percent of her home is used regularly for day care activities. The day care center is open 12 hours per day, five days per week, which amounts to 60 hours out of a possible 168. She must multiply her home office expenses of $10,000 by .80 to arrive at her business use percentage of $8,000, and then multiply this amount by 60/168 to arrive at her allowable deduction of $2,857.
Home office deduction limited to business income
Your home office deduction is limited by the amount of your net business income. If your net income is too low, you won't be able to deduct the entire amount of your home office deduction this year. You may deduct no more than your net income.
With most of your ordinary business expenses, if you have more expenses than you have income, your business can show a net operating loss that may be deductible against any other regular income you have (such as interest, dividends, or income from another job or business). This may even be true if the loss is a "paper loss" resulting from depreciation. However, the home office deduction cannot create a net operating loss.
The IRS has developed a rather lengthy computation that must be used in applying this limit, which is incorporated into IRS Form 8829, Expenses for Business Use of Your Home. After reviewing this form, you may opt for the simplified method. But, remember, the goal is to reduce your taxes and simple might not always be better.
Computing deduction using regular method
To compute the net income from your home-based business, you must start with your gross business income from all sources (sales, interest on bank accounts, etc.).
This is reduced by all of your business expenses that are not part of the home office deduction. In general, these are expenses that would be deductible regardless of whether you have a home office. The result is your tentative profit as shown on line 29 of your Schedule C, and is the maximum amount you can claim as a home office deduction this year.
Next, subtract the portion of your home office deduction expenses that you could otherwise use as itemized deductions: home mortgage interest, real estate taxes, and casualty losses computed as if the home office was your personal residence.
If the answer is zero or a negative number, you may be better off not claiming the home office deduction, and instead claiming these amounts as regular itemized deductions. This is especially true if you think your tax bracket next year won't be higher than your bracket this year.
Assuming the answer to the previous step was a positive number, subtract the portion of your home office deduction expenses that would not otherwise be deductible as itemized deductions: insurance, repairs and maintenance services, utilities, and rent if you don't own the home.
Finally, you may subtract the extra business portion of any casualty losses, depreciation on your home, and any carried-over home office expenses from previous years. If the end result is zero or a positive number, you can deduct all your home office expenses. If the end result is a negative number, you may carry over the nondeductible portion and deduct it in later years when you have sufficient net business income.
Example: Kay Mifflin is employed as an outside salesperson, and she meets all the requirements for deducting expenses for a home office. Her computation of expenses for the business use of her home is as follows:
Gross income from business:
less: direct business expenses (business phone, car expenses)
less: deductible mortgage interest and taxes
Home office deduction limitation
less: other expenses for business use of home
Balance (carried over to the next year)
As you can see, the amount of the deduction depends upon the portion of your home used, the length of time used, and your expenses.