If you qualify for the home office deduction, you can deduct a part of certain types of expenses that the normal homeowner cannot deduct.
You can deduct expenses directly related to operating your home office with the home office deduction. You can also deduct a share of certain home-related expenses that are not deductible for the average homeowner. Insurance, utilities, maintenance, security system costs, maid service, waste disposal, and decoration costs are among these costs.
You won’t have to worry about expenditure classification or allocation if you use the new Simplified Method to calculate your home office deductions.
You can claim $5 per square foot of home office space using the simple technique. By slogging through these computations, you may be able to claim a higher deduction, but the savings may not be worth the effort.
Determining if an expense is deductible.
- Only to the office at home. If an item is solely for the home office, the whole amount is deducted as a “direct” home office expense. The cost of window treatments put solely in your home office to provide seclusion for clients, for example, would be a direct expense.
- The whole house. If the expense is for the entire house, it is considered a “indirect” home office expense, and only a portion of it is deductible. Indirect expenses include things like heating, air conditioning, rent, and mortgage payments.
- Part that is not related to business. If the expense just applies to the non-business section of the home, none of it is deductible. Remodeling the master bathroom to include a personal sauna is an example of a nondeductible expense.
If you only conducted your business for part of the year (as is almost typically the case in the first and last years of a business), you can only deduct expenditures for the time you used the office.
Portion of insurance cost is deductible.
As part of the home office deduction, you can deduct the business percentage of your homeowner’s or renter’s insurance.
Tip: This amount does not include the costs of any company insurance you have or any unique home office policy riders. Those expenses are only deductible as standard company expenses, not as part of the home office deduction. This distinction is crucial if the amount of your business income limits your home office deduction.
Business portion of utility and maintenance costs can be deducted.
You can deduct the business share of your utility expenditures for heat and electricity, as well as services that apply to the entire property, such as trash collection, security, and maid or cleaning services.
Payments for lawn service are not eligible. Lawn service is normally not deductible as part of the home office deduction, even if the home office is utilized as a meeting site with clients, according to IRS regulations (who presumably view the lawn as they enter the residence.)
You can’t deduct any percentage of an expense for a utility or service that isn’t used in your firm at all. If you buy propane fuel for your kitchen exclusively and your business does not entail cooking, for example, no portion of the propane bill is deductible.
If you believe your company uses a lot more (or a lot less) of a specific utility, you should increase (or lower) your company’s percentage of the bill. Because this isn’t an exact science, the IRS will accept a reasonable estimateespecially if you can back it up with sound reasoning and accurate computations.
Anne is a representative for a cosmetics company who is eligible for the home office deduction. Lighting, cooking, laundry, and television are all included in her $400 power bill.
For business purposes, only the illumination is used. Anne calculates that lighting accounts for $250 of the total price. $25 may be deducted as a business expense because she uses 10% of the residence for business.
If Anne can show that she installed specific lighting for her job that consumes more energy than standard lighting, she may be able to deduct more than 10% of the cost as a home office deduction.
Second telephone line can be deducted.
Telephone costs are not included in the home office deduction since they are considered direct business expenses. As a result, even if you don’t qualify under the home office regulations, you may be allowed to deduct a portion of your home or cellular phone expense.
However, you will never be able to deduct the cost of basic telephone service on your home’s first line or on your cell phone. These are personal expenses that you would incur even if you were not a business owner. You can deduct any separately indicated expenditures for local or long distance business calls, even if the cost of the telephone service is not deductible. If you use the line entirely for business, you can also deduct the expense of adding a second phone line to your home.
Apportionment Required If Expenses Benefit Entire House
An expense’s deductibility is determined by whether it helps only your home office, your entire house including your home office, or components of your house that do not include your home office.
“Direct” home office expenses are those that directly benefit your business (for example, replacing the walls and repainting a previous bedroom that is now your office).
Direct expenses are tax deductible to the full extent of the law. Expenses that benefit the entire house (for example, repairing a leaky roof or re-carpeting the entire house) are termed “indirect” home office expenses and are deducted proportionately based on the percentage of the home used for business.
Expenses that primarily benefit the personal component of the home (such as installing a whirlpool tub in the master bedroom suite) are not deductible at all.
Rent, interest, taxes must be apportioned
The fraction of the rental, tax, or interest payments that is deductible for both renters and homeowners is determined by the percentage of the home’s space that is used for business. The percentage of time spent at the office will be a factor if you start or stop utilizing it throughout the year.
Rent. For those who rent their house, the home office deduction can be a significant tax benefit. Unlike a homeowner who can deduct mortgage interest and real estate taxes on an itemized basis, a renter does not receive any form of deduction for rent paid. The part of rent related to the commercial use of a renter’s house is deductible if they qualify for the home office deduction.
Interest on a mortgage. Homeowners can deduct a part of their real estate taxes as well as their eligible mortgage interest (but not principal) payments. The main benefit of the home office deduction for homeowners is that it changes an itemized deduction into a significantly more tax-advantaged business expenditure deduction. Mortgage interest and real estate taxes are deductible regardless of the home office deduction. Homeowners can also take advantage of a depreciation discount to recoup some of the cost of their home.
Interest on a second mortgage or a home equity loan may qualify as qualified mortgage interest. There are, however, financial limitations. Only interest on mortgages up to $1,000,000 ($500,000 if married filing separately) and home equity loans up to $100,000 ($50,000 if married filing separately) is deemed “qualified.” If you believe you may be subject to one of these limitations, speak with your tax advisor or obtain IRS Publication 936, Home Mortgage Interest Deduction, for more information on calculating your deduction.
The amount of taxes actually paid to the taxing authority on your behalf during the year is included in real estate taxes. This amount may differ from what your mortgage company needs you to put into an escrow account. The money paid to any homeowner’s association or condominium association is not included in real estate taxes. They also exclude assessments for municipal benefits such as streets, sidewalks, and water and sewer infrastructure, which may be depreciated instead.
Of course, regardless of whether they use their house for commercial purposes, homeowners can deduct all of their real estate taxes and qualifying mortgage interest as itemized deductions. However, claiming these costs as part of the home office deduction converts them from an itemized to a gross income deduction. This is significantly more advantageous in terms of lowering tax liability.
Another significant benefit is that by claiming these amounts as a business deduction, you minimize the amount of net income on which self-employment taxes must be paid.
Furthermore, claiming the home office deduction allows you to deduct some of your real estate taxes and mortgage interest from your adjusted gross income (AGI), which can improve your eligibility for IRAs, miscellaneous itemized deductions, and the deduction for medical expenses exceeding 7.5 percent of AGI.
Claiming home office depreciation
If you own your home and qualify for the home office deduction, you cannot deduct the amount you bought for it, the principal payments you make on your mortgage, or the fair rental value of the home. Instead, depreciation deductions might be used to recoup the cost of the commercial portion of the residence. (If you use the simple method to calculate your home office deduction, depreciation is not taken into account.)
Depreciation is a method of recovering an asset’s cost over its useful life. Instead of deducting the entire cost of a piece of property in the year of purchase, you deduct a portion of it each year, according to IRS procedures and tables.
Consider the future: There’s no denying that calculating and tracking depreciation is a pain. However, if you want to claim a home office deduction, you must do so immediately.
Why? Because whether you claim depreciation or not, the IRS will force you to deduct the amount of depreciation you should have claimed from the gain on the sale of your house.
If you don’t claim depreciation, you lose out twice: first, you won’t be able to reduce your annual tax bill as much as feasible, and second, you’ll be limiting the amount of gain you may exclude from income when you sell your house.
If claiming the home office deduction would not result in considerable total savings (for example, the business use percentage for your home is under 5%), you may want to consider bypassing the deduction. Work with your tax advisor to create a variety of scenarios so you can plan not only for this year, but for years to come.
Depreciation based on home’s tax basis
However, before you can calculate the actual amount of your depreciation, you’ll need to know your home’s tax basis.
To figure out what your home’s tax basis is, take the lowest of:
- the fair market value of your home at the time you start working from home, or
- the cost of the house (excluding the land beneath it), plus the worth of any permanent renovations you made before utilizing the home office, less any casualty losses you deducted before using it
In most circumstances, you’ll be utilizing the second of the two items listed above, but if you feel that the value of your home has decreased since you purchased it, you should have an appraisal done when you start using the home office to determine the fair market value at that time.
The price you paid for the house usually includes not only the purchase price, but also other closing costs and settlement fees. Abstract costs, utility installation fees, legal expenses, recording fees, surveys, transfer taxes, title insurance, and any monies you agree to pay on behalf of the seller, such as back taxes or interest, sales commissions, or charges for improvements or repairs, are among the most typical.
Insurance payments, rent for occupation prior to closing, and expenditures associated with obtaining a loan, such as mortgage insurance, credit reports, appraisal fees, loan assumption fees, and points, are not allowed to be included.
To calculate your tax basis for depreciation, you must apportion the entire costs of the property between the ground and the buildings on it in a reasonable manner. If the price was not clearly allocated in your sales contract, you should allocate the costs based on the fair market value of the land and buildings at the time of acquisition. Your realtor or insurance agent may be able to assist you in determining a fair market value estimate.
To figure out how much you can depreciate, multiply your tax basis by the percentage of your home that is used for business.
You multiply the tax basis of the depreciable section of the home by a proportion set by the IRS based on the month and year you started doing business from the home. The IRS publication 946, How to Depreciate Property, contains tables that show these fractions. In general, for real estate used for business on or after May 13, 1993, the depreciation term will be 39 years, and the appropriate fraction will be except in the first and last years. 02564. The percent for the first and last years will be determined by the month in which business use began or concluded.
If you started utilizing your home office before May 13, 1993, keep using the same depreciation method you started with.
Repairs are deducted; improvements are depreciated
You can deduct a portion of your repairs if you qualify for the home office deduction. In most cases, the cost of capital upgrades must be added to the property’s basis. Unlike other homeowners, though, you can depreciate your homebut only on the portion that is utilized as a home office.
It can be difficult to tell the difference between a repair that is deductible (in whole or in part) in the year it is made and an improvement that must be depreciated throughout the property’s useful life.
- adds to the value of your home in a tangible way,
- significantly extends its usable life, or
- applies it to new applications
A repair, on the other hand, simply preserves your home in good working order; it does not increase the value of your home or extend its life. If repairs are made as part of a larger remodeling or restoration project, the entire project is deemed a success.
Patching up walls and floors, painting, repairing roofs and gutters, repairing a furnace or air conditioner, and repairing leaks are all examples of repairs. Capital upgrades include things like new flooring, roofs and gutters, furnaces, and air conditioners.
Capital improvements must be depreciated
If you make a large, permanent improvement to your house after you start using it for business (rather than a repair), you will need to depreciate this capital expenditure as well. For example, if you place a new roof on your house or buy a new furnace, you would depreciate the cost of the improvement over 39 years, beginning with the month and year it was installed.
If you utilize any part of your home for business, even if you did not declare it, you must alter the basis of your home to account for any depreciation that was allowed for that use. Also, even if you did not claim depreciation, you must reduce the gain that can be excluded upon the sale of the residence by the amount of depreciation allowed.
Special rules govern home office casualty losses
If your home office is damaged or destroyed by a burglary or a disaster such as a hurricane, flood, fire, accident, riot, or vandalism and you qualify for the home office deduction, you may be eligible to deduct some of your losses as part of the home office deduction.
A sudden, accidental, or exceptional loss is referred to as a casualty loss. Damage from pets or progressive property losses such as erosion, termites or other insects, wood decay, and other slow-moving causes are not included in casualty losses.
Treat the loss as a “direct” expense that is entirely deductible if it exclusively affects the home office. If it applies to your full home, divide the amount between your home office and your personal use areas. Your allotment is dependent on your percentage of business use. You may not be able to deduct any of the loss as a business expense if it solely affected the non-business portion of your house, but you may be able to deduct it as a personal expense.
For instance, your home’s roof was severely damaged by a violent hail and wind storm. The percentage of your home that is used for business is 10%. As a result, only 10% of a casualty loss is deductible as a business loss. The rest could be deducted as a personal injury loss.
A tree also fell through the picture window in your family room, which is not part of your home office, due to the wind. There is no proration of this loss between the home office and the residence.
Insurance reimbursement affects loss deduction amount.
You must file a timely claim for any insurance you have on the property to claim a casualty loss, and you can only deduct the percentage of the loss that is not covered by insurance.
Calculate your losses using the amount you reasonably expect to receive from the insurance carrier if the reimbursable amount has not been decided by the time you need to file your tax return. If your estimate is off, you can include any additional reimbursement as income in the year you get it, or you can file an amended return for the year you suffered the loss if you don’t recover as much as you expected.
Warning: If you get more insurance money than your adjusted basis in the property at the time of the loss, you may have a taxable gain unless you buy replacement property within two years, or four years if the loss happened in a federally declared disaster area. For more information, see IRS Publication 547, Casualties, Disasters, and Thefts.
Business loss rules are more tax-advantaged
For company property, the regulations for deducting casualty losses are more favorable than for personal property.
For starters, personal property losses are subject to two thresholds: a $100 per occurrence limitation, which means the first $100 is not deductible, and a 10% of adjusted gross income (AGI) limit. To put it another way, once you’ve deducted the initial $100, you can only deduct the fraction of the remaining loss that exceeds 10% of your AGI. These limitations do not apply to business property casualty losses.
Second, business casualty losses are calculated using slightly different rules than personal casualty losses. If the property is just damaged, you must take the lowest of the drop in the property’s fair market value (FMV) as a result of the loss or the property’s adjusted basis prior to the casualty loss for both types of losses. To get at the amount of loss, remove any insurance reimbursement from this.
Start with the lowest of the property’s FMV or adjusted basis before the loss if personal property is fully destroyed. If a business property is fully destroyed, however, begin with the adjusted basis before the loss, minus any salvage value; the property’s FMV is not taken into account.
You must compute the loss both ways in order to claim a casualty loss on your home office. First, using the $100 and 10%-of-AGI levels outlined above, calculate the amount of loss you’d be able to deduct if the office wasn’t used for business. Then, as a business expense, calculate the amount of loss on the home office. Using IRS Form 4684, Casualties and Thefts, as a worksheet, is the simplest approach to calculate these two amounts. Part A should be filled out as if the loss occurred on personal property, and Part B should be filled out as if the loss occurred on company property.
While the amount that would be deductible as a personal loss (as stated on Part A) is always itemized, the difference between the personal and company losses will only be deductible this year if your business income is adequate to pay all of your business expenses. If not, you can carry the surplus over to the following year and deduct it.
Property tax basis is reduced as a result of casualty losses. Your deductible casualty losses must be applied to the business component of your home’s tax basis. You must calculate your depreciation deductions using this revised basis for the year of the loss and subsequent years. See IRS Publication 946, How To Depreciate Property, for additional details.