Don’t gamble on the details.
Red flag and IRS — two things you never want to see in the same sentence. If you’re self-employed or have a small business, chances are somewhere along the way, you’ve been told that deducting a portion of your housing costs will be a red flag for an audit.
However, this isn’t necessarily the case. And if you legitimately qualify for the home office deduction, there’s no reason to avoid it. After all, the typical home office deduction will run into the thousands of dollars. It’s substantial and well worth the effort (far more so than scouring your car for a missing receipt for printer ink)…
So, how can you make sure you can take as much of a deduction that’s allowed to you, while minimizing your chance of an audit? The key is knowing (and following) the rules. According to the IRS (Publication 587), “To qualify to deduct expenses for business use of your home, you must use part of your home:
Exclusively and regularly as your principal place of business
Exclusively and regularly as a place where you meet or deal with patients, clients, or customers in the normal course of your trade or business”
Decoding the Elusive “Exclusive Use”
The word “exclusive” shows up frequently in the IRS definition of a deductible home office. If you use any portion of your home exclusively for business purposes, you’re entitled to claim a home office deduction for that space. But just what does “exclusive” mean? In short, it’s a space that you use solely for your business, and nothing else. For example…
If you have a blogging business and do the bulk of your writing at the dining room table, you can’t take any deduction for the dining room if you ever eat there, host dinner parties, or use the dining room for anything else other than your blog.
Let’s say you’re a freelance application developer and have set aside a desk for your workstation and server in the bedroom. You can deduct the area around your desk as your exclusive work space (assuming this space is used only for your business).
Of course, the above examples are rather straightforward and we all know that tax matters are rarely cut and dry when it comes to your business.
For example, let’s say you’re a self-employed designer and rent a studio outside your home. But occasionally, you invite potential clients to your home to review your portfolio in your living room. Since your living room isn’t an exclusive place of business, you can’t deduct this. But, if you designate a spare room in your house as a client meeting area, then you can deduct this area.
Let’s say you’re a plumber who makes house calls. Your primary place of work is in clients’ bathrooms or kitchens. However, you can claim a home office deduction if you use part of your home to handle the bookkeeping, administrative, and other management activities for your business. Again, this space qualifies only if it’s used exclusively for your plumbing business.
If you’re a telecommuting employee (and not an independent contractor), home office deductions get even trickier. In this case, you must be working from home for your employer’s convenience. Let’s say you’re a virtual call center agent or data entry specialist and your company saves money on office space by hiring agents to work from home. In this case, you can deduct your home office space using Form 2016. However, if your employer lets you work from home because your commute is long (and the employer does have office space available for you), then you don’t qualify for the deduction.
Taking Your Deduction
Home office deductions are based on the percentage of your home that is used for business purposes. The first thing you need to do is figure out the total square footage of your home, and then the square footage of the space that’s designated as an exclusive office or working area.
If you use a spare room (180 sq ft.) as an office and your home is 1,900 sq. ft., then you can write off 9.5% of certain home expenses, including: rent or mortgage payments, insurance (homeowners or renters), and utilities. Direct costs relating to the space, such as repairs or paint, can also be deducted.
The rules around other expenses can be a little fuzzy. Can you deduct a stereo as a business expense? What about an expensive painting or a designer rug for your workspace? Tax experts tend to give a few general guidelines for these questions.
Will the expense bring your business more profit (i.e. increase your productivity or sales)? Expensing a desk lamp that helps you see can certainly be defended. If you meet with clients in your home office, then aesthetic elements (like a painting) may be eligible for deduction. However, these expenses should be ordinary and standard, meaning that other business owners would have the same expense at a similar price point.
It’s also important to note that the rules have loosened with regard to how profits are taxed when you sell your home. In the past, if you used 9% of your home as an office (and had been taking the home office deduction), when you sold your house, 9% would not qualify as tax-free under the rules that allow up to $250K tax-free profits for individuals, $500K for joint returns. This no longer applies. However, you do have to pay tax on any profit resulting from depreciation claimed for the office.
What About an S-Corp, C-Corp, or LLC?
The above scenarios apply to self-employed sole proprietors. But let’s say you decided to form an LLC or Corporation in order to separate your personal and business expenses, minimize your personal liability, and perhaps lower your overall taxes. Deducting the use of a home office is handled differently here, but it is still possible. Talking to your accountant will be the easiest way to figure out the most favorable solution for both the corporation and shareholder.
For example, in an S-Corp situation where one of the shareholders uses a home office as his principal office, the corporation can reimburse the shareholder for the home office costs on a monthly basis under an accountable expense reimbursement plan. This becomes a deductible business expense for the corporation.