All over the country there are small business owners who are running their business from an extra bedroom in their home, a basement, or even their garage. It may be a humble beginning but many of the country’s largest companies have started in a similar fashion: Amazon, Apple, Disney, and Under Armour to name a few. In an effort to recognize the costs that entrepreneurs are incurring by running their business from home the IRS has what is known as a Home Office Deduction.
The IRS allows self-employed individuals who file their business tax-returns on a Schedule C, to deduct certain home office expenses. In order to qualify for this deduction the IRS mandates that two requirements must be met.
1)Regular and exclusive use: You must regularly use the same part of your home exclusively for business purposes. For example if you regularly use an extra bedroom as an office, you can take the deduction. If, however, you use a guest bedroom that family stays in when they come to visit you cannot claim the home office deduction.
2)Principal place of business: You must be able to document that you use your home as your principal place of business. If you conduct parts of your business away from home (think meetings with clients) but also use your home substantially and regularly to carry out your business you can still claim the deduction.
If you are an employee you may still be able to deduct your home office expenses if you work from home for your employer’s convenience and the employer is not paying you rent. However, as an employee your deduction will be a miscellaneous itemized deduction and subject to a 2% floor. That means the deduction that can be taken will only be the amount that exceeds 2% of your adjusted gross income.
Once you determine whether you qualify to take the deduction it is up to you (or your accountant) to determine which method you should take to claim your home office deduction. New in 2013, there are two methods you can use to determine your deduction, the Simplified Method or the Actual Expenses Method.
The Simplified Method requires you to know only what square footage of your home you use for business purpose. Once you know the square footage that you use exclusively for business that number is multiplied by $5 (the prescribed IRS rate). For example, if Jane uses a 10 by 10 room (or 100 square feet) exclusively for business she would multiply 100 by the $5 prescribed IRS rate. Her deduction would be $500. The IRS does limit this deduction to a maximum of 300 square feet, or $1,500.
The Actual Expenses Method allows you to deduct those bona fide business expenses incurred over the year. In general you will be required to determine whether your expenses are direct, indirect or unrelated. You will also be required to know what square footage of your home is used exclusively for business purposes.
Direct expenses are those costs that are incurred for only the business portion of your home, and they are deductible in full. An example of this would be painting or repairs in the area exclusively used for business.
Indirect expenses are those costs that are incurred for keeping the home up and running throughout the year. These are deductible based on the percentage business use of your home. Examples of these types of expenses would be insurance and utilities.
As a brief example, Jane uses 100 square feet or her 1,000 foot home exclusively for business purposes. Jane incurs a $200 repair bill for the area exclusively used for business, $2,000 in household utilities, and $500 for homeowners insurance. The repair would be considered a direct expense and is deductible entirely. The utilities and homeowners insurance are indirect expenses and are deductible only for the 10% (100/1,000) business use of the home. Jane’s deduction would be calculated by adding the $200 of direct expenses to $250 of indirect expenses (10% times $2,500). Her total deduction would be $450 dollars.
It is always advisable to contact your CPA before claiming any deduction. Your tax advisor will be able to explain any caveats to general rules, help maximize your deduction, and make sure that all necessary forms are filled out.