Editors' pick: Originally published Feb. 10.
The first Sunday in February brings a lot of excitement with the last NFL game of the season - the Super Bowl. But February also marks the start of the busiest time of the year for accountants - tax time, or as some tax professionals consider it, their own personal "Super Bowl."
By now, you should have received most of your pertinent tax documents and may have already gotten organized and started working through what deductions may be available to you. One deduction, the home office deduction, is not nearly utilized as much as it could be. The IRS claims that 26 million Americans have home offices, but just 3.4 million taxpayers claim the home office deduction.
Are You Eligible?
A home office is exactly what it sounds like - an office in your home. Traditionally, the home office deduction is most associated with small business owners, but certain employees may be eligible for the deduction as well.
All types of folks may have an office in their home, but for it to be deductible for tax purposes, the space must be used exclusively and regularly for business purposes; it can't be used for personal activities. The office could be in a separate room or in the same room as your personal activities, as long as there is a clear physical divide. In addition, the home office must be a principal place of business or a place where you meet with clients regularly.
For employees of companies, you generally aren't allowed to take the home office deduction unless you work at home for the convenience of your employer. For example, if your employer doesn't have a physical office location, you may be eligible to take the home office write-off. However, if your employer does have an office, but you happen to work from home every Friday for your own convenience, you're technically not eligible to take the office deduction.
"Most employees will have a tough time meeting the conditions to take a home office deduction," says David Oransky, a CPA financial planner for Laminar Wealth. "Even if they are eligible, they would have to itemize deductions on Schedule A instead of taking the standard deduction, which may not be advantageous."
There are three types of expenses that are deductible for home office purposes:
1. Direct Expenses: These expenses only benefit your business, such as office supplies, computers or even paint for the office walls. You can deduct the full cost of these expenses.
2. Indirect Expenses: These expenses benefit both your personal and business activities. Examples of indirect expenses could be mortgage interest or rent, utility bills, homeowner's or renter's insurance, and a security system. Since these expenses apply to both the personal and business part of your home, you can only deduct a portion of these expenses for the home office deduction.
3. Depreciation: If you own your home, you can depreciate the portion of your home that the office represents over 39.5 years. For example, assume you had a 1,000 square foot home with a 100 square foot office that originally cost you $500,000. The home office represents 10% of your home (100/1,000).
As such, you would be able to depreciate $50,000 ($500,000 x 10%) over 39.5 years or about $1,270 per year ($50,000/39.5). This would allow you to write off $1,270 of depreciation on your taxes each year.
Note that you'll need to adjust the cost basis on your home down by $1,270 each year. If you end up selling your home for more than your adjusted cost basis, you'll be subject to unrecaptured depreciation at a rate of 25% for the amount between your original cost basis and your adjusted cost basis. Any appreciation above your original cost basis may be eligible for the $250,000 capital gains home exclusion.
Channeling Your Inner Mathlete
To figure out your home office deduction, you have two methods to choose from - the easy way or the hard way. The easy way involves calculating the percentage of your home used for business and converting that to a square footage amount. You would then multiply the square footage by $5 per square foot. Under the easy method, or as the IRS calls it, the "simplified method," you can deduct up to $1,500, or a maximum of 300 square feet. If you think your home office expenses are greater than $1,500, it may be more advantageous for you to try the more involved calculation.
"If you rent your home, it is usually worthwhile to at least also calculate the deduction using the regular method and see which is bigger," Oransky added. "Compared to homeowners, it is generally easier for renters to calculate the deduction using the more involved method and often provides greater value."
The harder method involves calculating the percentage of your home used for business and then using that percentage to come up with the business portion of your indirect expenses. You can then add that number to your direct expenses and for homeowners, your depreciation.
To make it official, you'll fill out Form 8829 to deduct your expenses via the more involved method. The final numbers will go on your Schedule C if you're a small business owner. If you're an employee, your deductions will fall on your Schedule A as miscellaneous itemized deductions, which are subject to a 2% adjusted gross income floor.
The Bottom Line
In the past, some people have thought utilizing the home office deduction may trigger a red flag and ultimately an IRS audit. But if you're eligible for the home office deduction, there's no reason not to take it. The IRS has also removed additional barriers to taking the deduction with the introduction of the simplified calculation option, which makes it fairly easy to determine the deduction amount.
"If you have a legitimate home office, but have avoided the home office deduction in the past, because the calculations and record-keeping seemed onerous or audit-prone, the simplified method is an easy way to at least get some of the tax deduction you have been missing out on," Oransky concluded.
As with other tax matters, it's always good to keep accurate records of eligible expenses incurred, and if you need additional guidance for your specific situation, consider consulting with a tax professional.