If you qualify for the home office deduction, you may claim a portion of certain types of expenses that are usually not deductible by the average homeowner.
The home office deduction allows you to deduct expenses directly related to maintaining your home office. You can also deduct a portion of certain expenses that are associated with your home, but are not deductible by the average homeowner. These expenses include insurance, utilities, repairs, security system expenses, maid service, garbage disposal, and decorating expenses.
If you are using the new Simplified Method to determine your home office deductions, you do not need to worry about the classification or allocation of expenses.
Under the simplified method, you are entitled to claim $5 per square foot of home office space. Oftentimes, you will be able to claim a larger deduction by slogging through these calculations, but the savings may not justify the hassle.
Determining if an expense is deductible.
These general rules apply to determine whether an expense is deductible.
- Only to home office. If a given expense pertains only to the home office, the entire expense will be deductible as a "direct" home office expense. For example, the cost of window treatments installed only in your home office to ensure privacy for clients would be a direct expense
- Entire house. If the expense applies to the entire house, it's an "indirect" home office expense and only a proportionate part of it will be deductible. Heating, air-conditioning, rent or mortgage payments are examples of indirect expenses.
- Non-business portion. If the expense applies only to the non-business portion of the house, none of the expense will be deductible. An example of a nondeductible expense would be remodeling the master bathroom to install a personal sauna.
If you only operated your business for a portion of the year (which is nearly always true in the first and last year of a business), you may only deduct expenses for the portion of the year in which the office was used.
Portion of insurance cost is deductible.
You may deduct the business percentage of your homeowner's or renter's insurance as part of the home office deduction.
Tip: Do not include the costs of any business insurance you carry or special home office policy riders in this figure. Those costs apply specifically to the business portion of your home, and are fully deductible as ordinary business expenses, not as part of the home office deduction. This distinction can become important if your home office deduction is limited by the amount of your business income.
Business portion of utility and maintenance costs can be deducted.
As a general rule, you can deduct the business percentage of your utility payments for heat and electricity, and for services that pertain to the entire house such as trash collection, security services, and maid or cleaning services.
Warning: Lawn service payments do not qualify. IRS regulations indicate that lawn service is generally not deductible as part of the home office deduction, even when the home office is used as a meeting place with clients (who presumably view the lawn as they enter the residence.)
If you pay for a utility or service that's not used in your business at all, you can't deduct any portion of the expense. For instance, if you buy propane fuel that is used only in your kitchen and your business does not involve cooking, no part of the propane bill is deductible.
If you believe that your business accounts for significantly more (or less) of a particular utility, you should increase (or decrease) your business percentage of that utility bill accordingly. This is not an exact science, and the IRS will accept a reasonable estimate--especially if you can provide a sound justification that is supported by accurate calculations.
Example: Anne is a cosmetics company representative who qualifies for the home office deduction. Her $400 electric bill covers lighting, cooking, laundry and television.
Only the lighting is used for business. Anne determines that $250 of the bill is for lighting alone. Because she uses 10 percent of the house for business, $25 may be deductible as a business expense.
However, if Anne can establish that she installed special lighting necessary for her work and that lighting uses more power than ordinary lighting, she may be justified in claiming more than 10 percent of that bill as a home office deduction.
Second telephone line can be deducted.
Telephone bills are considered direct business expenses, and are not part of the home office deduction. Therefore, you may be able to deduct a portion of your home or cellular phone bill even if you don't qualify under the home office rules.
However, you can't ever claim any deduction for the basic telephone service on the first telephone line in your home, or on your cellular phone. These are considered to be personal expenses that you would incur even if you did not own a business. Even though you can not deduct the cost of the telephone service, you can deduct any separately stated charges for local or long distance business calls. You can also deduct the cost of bringing a second phone line into your home, if you use the line exclusively for business.
Apportionment Required If Expenses Benefit Entire House
The deductibility of an expense depends upon whether it benefits just the home office, your entire house including your home office or portions of the house that do not include your home office.
Expenses that exclusively benefit your business (for example, repairing the drywall and repainting a former bedroom that is now your office) are considered "direct" home office expenses.
Direct expenses are fully deductible. Expenses that benefit the entire home (for example, patching the roof so it doesn't leak, or re-carpeting the entire house) are considered "indirect" home office expenses that are proportionately deductible based upon the percentage of business use of the home.
Expenses that benefit only the personal portion of the home (for example, installing a whirlpool tub in the master bedroom suite) are not deductible at all.
Rent, interest, taxes must be apportioned
For both renters and homeowners, the deductible portion of the rental, tax, or interest payments depends on the percentage of the home's space that is used for business. If you start or stop using the office during the year, the percentage of time that the office is used will also be a factor.
Rent. The home office deduction can be a real tax break for those who rent their home. Unlike a home owner, can claim an itemized deduction for mortgage interest and real estate taxes, the renter doesn't get any type of deduction for rent paid. However, if a renter can qualify for the home office deduction, the portion of rent attributable to the business use of a their home is deductible.
Mortgage interest.. Homeowners may deduct a portion of both real estate taxes and qualified mortgage interest (but not principal) payments on the home. Because mortgage interest and real estate taxes are deductible without regard to the home office deduction, the real advantage of the home office deduction for homeowners is that it converts an itemized deduction into a far more tax-advantaged business expense deduction. Homeowners can also claim a depreciation deduction to recover some of the home's purchase price.
Qualified mortgage interest may include interest on a second mortgage, or a home equity loan. However, there are dollar limits that apply. Only interest on mortgages up to $1,000,000 ($500,000 if married filing separately) used to buy, build, or improve your property, and interest on home equity loans up to $100,000 ($50,000 if married filing separately), is considered "qualified." If you think either of these limits might apply to you, consult your tax advisor or get IRS Publication 936, Home Mortgage Interest Deduction, for more detailed information on computing your deduction.
Real estate taxes include the amount of taxes actually paid to the taxing authority on your behalf during the year. This may be different from the amount that your mortgage holder requires you to pay into an escrow account. Real estate taxes do not include amounts paid to any homeowner's association or condominium association. They also don't include assessments for local benefits like streets, sidewalks, or water and sewer systems - instead, these amounts may be depreciated.
Of course, homeowners would be able to deduct all their real estate taxes and qualified mortgage interest as itemized deductions, regardless of whether they use their home for business purposes. However, claiming these expenses as part of the home office deduction shift them from an itemized deduction to a deduction from gross income. This is far more beneficial in reducing tax liability.
Another major advantage to this is that by claiming these amounts as a business deduction, you reduce the net income on which you must pay self-employment taxes.
Furthermore, claiming the home office deduction means that some of your real estate taxes and mortgage interest will be used to reduce your adjusted gross income (AGI), which in turn can improve your eligibility for numerous tax benefits including IRAs, miscellaneous itemized deductions, and the deduction for medical expenses that exceed 7.5 percent of AGI.
Claiming home office depreciation
If you qualify for the home office deduction and you own your home, you can't directly deduct the price you paid for the home, the principal payments you make on the mortgage, or the fair rental value of the home. Instead, you can recover the cost of the business percentage of the home through depreciation deductions. (Note that depreciation is not a factor if you use the simplified method to determine your home office deduction.)
Depreciation is a way to recover the cost of an asset over its useful life. Rather than deducting the entire cost of a piece of property in the year of purchase, you deduct a portion of it each year, using methods and tables established by the IRS.
Think ahead: There is no doubt that calculating and tracking depreciation is a real headache. However, if you are going to claim a home office deduction it is critical that you do so.
Why? Because whether you claim depreciation or not, the IRS is going to require that you reduce the gain received on the sale of your home by the amount of depreciation that you should have claimed.
If you don't claim depreciation, you lose out twice—first, by not lowering your annual tax bill by the largest amount possible and, second, by reducing the amount of gain that you can exclude from income when you sell your home.
If you are not going to realize significant overall savings from claiming the home office deduction (for example, the business use percentage for your home is only five percent) then you may want to consider foregoing the deduction. Work with your tax professional to generate various scenarios so you plan not only for this year, but for years down the road.
Depreciation based on home's tax basis
Before you can calculate the dollar amount of your depreciation, however, you will need to know the tax basis of your home.
To determine your home's tax basis, you start with the lower of:
- the home's fair market value at the time you begin using the home office, or
- the cost of the home (not including the cost of the land underneath it), plus the value of any permanent improvements you made before using the home office, and minus any casualty losses you deducted before using it.
In many cases, you'll be using the second of the two items listed above, but if you suspect that your home has slid down in value since you bought it, you should have an appraisal done when you start using the home office in order to fix the fair market value at that point in time.
The cost of the home generally includes not only the price you paid to the seller, but also various closing costs and settlement fees. The more common of these are abstract fees, installation of utility services, legal fees, recording fees, surveys, transfer taxes, title insurance, and any amounts you agree to pay on behalf of the seller such as back taxes or interest, sales commissions, or charges for improvements or repairs.
However, you may not include are insurance premiums, rent for occupancy before closing, and charges connected with getting a loan such as mortgage insurance, credit reports, appraisal fees, loan assumption fees, and points.
You must reasonably allocate the total costs of the property between the land and the buildings on it to compute your tax basis for depreciation. If your sales contract did not explicitly allocate the price, you should allocate the costs on the basis of the fair market values of the land and buildings at the time of purchase. Your realtor or insurance agent may be able to help you make a reasonable estimate of fair market value.
Your tax basis must be multiplied by the business use percentage of your home, to arrive at the amount you can depreciate.
Once you know the tax basis of the depreciable portion of the home, you multiply it by a fraction determined by the IRS, based on the month and year you began using the home for business. Tables showing these fractions are available in IRS Publication 946, How to Depreciate Property. Generally speaking, for real estate that you began using for business on or after May 13, 1993, the depreciation period will be 39 years and in every year but the first and the last, the applicable fraction will be .02564. For the first and last years, the fraction will depend on the month in which business use began or ended.
If you began using your home office before May 13, 1993, continue using the depreciation method that you originally started out with.
Repairs are deducted; improvements are depreciated
If you can claim the home office deduction, then you can deduct a portion of your repairs. Generally the cost of capital improvements must be added to the basis of the property. However, unlike most homeowners, you can claim depreciation on your home--but only on the part used as a home office.
It's sometimes difficult to distinguish between a repair, which is deductible (fully or partially) in the year it was done, and an improvement, which must be depreciated over the course of property's useful life.
According to the IRS, an improvement
- materially adds to the value of your home,
- considerably prolongs its useful life, or
- adapts it to new uses.
In contrast, a repair merely keeps your home in ordinary efficient operating condition; it does not add to the value of your home or prolong its life. If repairs are done as part of extensive remodeling or restoration, the entire job is considered an improvement.
Generally speaking, patching walls and floors, painting, repairing roofs and gutters, fixing a furnace or air conditioner, and mending leaks would be considered repairs. Installing new flooring, roofs and gutters, furnaces, or air conditioners would be considered capital improvements.
Capital improvements must be depreciated
If, after you begin using your home for business, you make a significant, permanent improvement to the property (as opposed to a repair) you will need to depreciate this capital expenditure as well. For example, if you put on a new roof or buy a new furnace for your home, you would depreciate the business percentage of the cost of the improvement over 39 years, beginning with the month and year of installation.
If you use any part of your home for business, you must adjust the basis of your home for any depreciation that was allowable for its business use, even if you did not claim it. Also, you must reduce the gain that can be excluded upon the sale of the home by the amount of depreciation allowable--even if you did not bother to claim it.
Special rules govern home office casualty losses
If you qualify for the home office deduction and your home office is damaged or destroyed by a burglary or a disaster such as a hurricane, flood, fire, accident, riot, or vandalism, you may be able to deduct some of your losses as part of the home office deduction.
Casualty losses imply a sudden, accidental, or unusual loss. Casualty losses do not include damage from pets or progressive losses to property such as damage from erosion, termites or other insects, wood rot, and similar slow-moving causes.
If the loss occurs only to the home office, treat it as a "direct" expense that is fully deductible. If it applies to the entire home, you will need to allocate the amount between the home office portion of your house and the personal use portion. You make the allocation based upon your business use percentage. If the loss occurred only to the non-business part of the home, you may not deduct any of it as a business expense, although you may be able to deduct it as a personal expense.
Example: A severe hail and wind storm caused extensive damage to the roof of your home. The business use percentage of your home is 10 percent. Therefore, only 10 percent of the casualty loss will be deductible as a business loss. The remainder may be deductible as a personal casualty loss.
In addition, the wind caused a tree to fall through the picture window in your family room, which is not part of your home office. The amount of this loss is not prorated between the home office and the residence.
Insurance reimbursement affects loss deduction amount.
To claim a casualty loss you must file a timely claim for any insurance you have on the property, and you can only deduct the portion of the loss that is not reimbursed by insurance.
If the reimbursable amount has not been determined by the time you need to file your tax return, compute your losses using the amount that you reasonably expect to eventually recover from the insurance company. If your estimate is incorrect, you can treat any additional reimbursement as income in the year you actually receive it, or file an amended return for the year of the loss if you don't recover as much as you expected.
Warning: If you recover more insurance money than your adjusted basis in the property at the time of the loss, you may actually have a taxable gain unless you purchase replacement property within two years, or within four years if the loss occurred to your main home located in a federally declared disaster area. See IRS Publication 547, Casualties, Disasters, and Thefts, for more details.
Business loss rules are more tax-advantaged
The rules for deducting casualty losses are more favorable for business property than for personal property.
For one thing, losses on personal property are subject to two thresholds: a $100 per occurrence threshold, which means that the first $100 is not deductible at all, and a 10 percent of adjusted gross income (AGI) limit. In other words, after the first $100 is subtracted, you can only deduct the portion of the remaining loss that exceeds 10 percent of your AGI. Neither of these limits apply to casualty losses on business property.
Secondly, business casualty losses are measured using slightly different rules. For both kinds of losses, if the property is only damaged, you must take the lower of the decrease in the property's fair market value (FMV) as a result of the loss, or the property's adjusted basis before the casualty loss. From this you subtract any insurance reimbursement, to arrive at the amount of loss.
If personal property is completely destroyed, start with the lower of the property's FMV or adjusted basis before the loss. But if business property is completely destroyed, start with the adjusted basis before the loss minus any salvage value; the property's FMV is not considered.
In order to claim a casualty loss on your home office, you must compute the loss both ways. First, compute the amount of loss that you'd be allowed to deduct if the office was not used for business, using the $100 and 10-percent-of-AGI thresholds described above. Then, compute the amount of loss on the home office as a business expense. The easiest way to compute these two amounts is to use IRS Form 4684, Casualties and Thefts, as a worksheet. Complete Part A as if the loss were on personal property, and then complete Part B as if the property were business.
While the amount that would be deductible as a personal loss (as shown on Part A) is always deductible as an itemized deduction, the difference between the personal loss and the business loss will only be deductible this year if your business income is sufficient to cover all your business expenses. If not, you can carry over the excess and deduct it next year.
Casualty losses reduce property's tax basis. Your deductible casualty losses must be used to reduce your tax basis in the business portion of the home. For the year of the loss and for subsequent years, you will need to use this new basis in calculating your depreciation deductions. For more information, see IRS Publication 946, How To Depreciate Property.