If you use part of your home regularly and exclusively for business you may be entitled to a deduction for the expenses associated with maintaining that work space whether you are self-employed or an employee. However, for an employee expenses are deductible only if the space is used for the convenience of the employer.
This deduction is most valuable to the self-employed because it is a deduction against self-employment income. For employees the business use of a home is a miscellaneous itemized deduction, grouped with other deductions that must exceed 2% of adjusted gross income to be added to itemized deductions.
To qualify as a home office the space must be used either as the principal place of business or a place to meet with clients. If it’s a separate structure not attached to your home it must be used in connection with the business. The area must be used on a continuing basis and for business use only. It need not be physically separated from the rest of the home to qualify. There are exceptions to the exclusive use requirement for day care centers and areas used to store inventory. Also, two businesses may share the space. They would each be entitled to a percentage of the allowable expenses based on their proportionate use of the space.
What expenses are deductible?
Expenses are either direct or indirect expenses. Indirect expenses are the general expenses for maintaining the entire home: depreciation, mortgage interest, real estate taxes, insurance, utilities, etc. Direct expenses like painting or repairs are related exclusively to the space used as the home office. Direct expenses are fully deductible. Indirect expenses are allocated to the home office based on the percentage of the structure used for business. There is a deduction limit for the self-employed, however. After the business portion of mortgage interest and real estate taxes are deducted from business income, the remaining allowable expenses cannot reduce business income below zero. Excess expenses are carried forward to future years.
What to do when it’s all too complicated?
There is now a simplified method of determining allowable home office expenses. To use this method the square footage of the office (up to 300 square feet) is multiplied by $5. The result is deducted from business income but cannot reduce it below zero. Under this method, no depreciation is taken on the space and 100% of mortgage interest and real estate taxes on the home are deducted on Schedule A. The election to use the simplified method can be changed annually.
For more information on this complicated and often challenged deduction, contact your tax preparer.