As a small business owner you can deduct part of your home expenses from your taxable income. You are eligible to take the home office deduction if:
- You are in business and use your office exclusively for business
- Use your home office for business on a regular basis
Calculating the home office deduction
To calculate your home office deduction, you need to :
Step 1 – Calculate the square footage of your home
The first step to calculating your home office deduction is calculating what percentage of your home you use as your home office. There are generally two methods namely:
Square footage method
The most accurate way of measuring your office space is the square footage method. For example using 200 square foot of your 2,000 square foot home is 10%. You are allowed to exclude square footage of common areas such as hallways – from the total area measured. Excluding common areas, gives you a higher deduction percentage.
Room Method
If the rooms in your house are all the same size, you can use the room method to decide your business deduction. To get the percentage, divide the number of rooms used for business by the total number of rooms used in the home. You do not include bathroom or closets as rooms while using this method. For example, if you have a five bedroom house and you use one room for business, your percentage usage will be 20%.
Step 2 – Determine deductible expenses
Once you determine the percentage, you have to multiply the cost of running your home by the percentage. Not all cost of running your home qualify. Moreover some expenses are fully deductible (direct expenses) and some are partially deductible (indirect expenses).
Direct expenses
Direct expenses are expenses that are directly related to your home office. For example, if you have a cleaning lady come in monthly specifically to clean your home office that is a direct expense and will be fully deductible.
Indirect expenses
Indirect expenses are the cost you use in running your home but partially deductible as part of your home office business expense. This is where you use the percentage calculated in step one to compute your business deductions. For example if your rent is $1,000 a month and your home office percentage is 20%, $200 will be deducted as home office deduction. Some indirect expenses allowed as part of the home office deduction are:
- Rent and utilities
- Mortgage interest
- Home/ Renters insurance
- Home maintenance and repairs
- Property taxes
- Depreciation of your home
- Association fees
- Security systems
Limitation on deduction
You cannot deduct the cost of a basic telephone line into your home. However, you can deduct the cost of a second telephone line, long distance and special phone services that you use for your business.
Moreover, your home office deduction is limited to the net profit earnings of your business.
Selling your home and the home office deduction
Home owners are entitled to excluding $250,000 gain from the sale of their home. If your home office is within your home, your entire profit is still eligible for the exclusion provided you meet the other requirements for the exclusion.
However, if your home office is attached to your home as opposed to within your home, you must allocate your gains from the sale of your home between the business and personal use. To avoid this, simply locate your home office within your home.
Simplified Office Deduction Method
To simplify the home office deduction, the IRS has created a new simplified optional home office deduction method. The eligibility rules still apply but rather than allocating cost of running your home to your home office business deduction, you can now use a standard rate. You can deduct $5 for ever square foot you use for your home office. This method eliminates the need to figure out the percentage of your home used as part of running your business. One caveat, is that your home office deduction is capped at $1,500 using the simplified method.
The great thing about the simplified method is that it eliminates some of the limitations of the home office deduction such as apportioning your mortgage interest and taxes between your business and personal tax return. Moreover, with the simplified method you no longer have to pay taxes on recaptured depreciation deductions on your home office.
Determining your deduction using both methods could be beneficial as sometimes the regular method still allows the higher deduction. As always, contact your tax professional for more specific advice.