Main Points
- Home Office Use Deduction is another useful deduction that’s often missed by small business owners working exclusively from home.
- There are two methods: A simplified method at $5/ft2 capped at $1,500 with minimal recordkeeping requirements; and the regular method that allows direct and indirect expenses to be applied.
- Neither method can completely wipe out the taxable income from your business. If operating at a business loss, you cannot take the deduction.
- Stick to one method when filing in future years.
America’s small businesses take on many different shapes and sizes. Some rent spaces in bustling downtown districts, others in alley-side single office rentals, and some even operate as contractors on coastal oil rigs. These operations vastly differ and can be very rigid since proximity to customers can be extremely important. Others may operate a small organic farm in a small township in Ohio, where the owner sells his produce and livestock from the outside, and manages his operation out of a small room in his home. Often overlooked, many sole proprietors and single member LLCs have a designated space in their homes where they work and miss out on the opportunity to take a deduction. Depending on the type of trade or business, these deductions can go a long way to reduce the taxable income generated out of your home. How is this done and how do you stay above board with the IRS for claiming it?
An Introduction
Chances are, you learnt about the “cottage industry” in late elementary school during social studies. This style of work was prevalent prior to the industrial revolution when the phrase was coined in 17th and 18th century England, to denote the nature of the business operated out of one’s home1. These trades were typically hard physical labor to produce goods like pottery, tools, weaves, as well as baked goods and cheeses (cottage cheese, for example). Since the industrial revolution, the number of these family businesses dwindled as mass production dominated, making goods more affordable through economies of scale, though the cottage industry didn’t vanish.
Today, the dynamic of the cottage industry shifted to more personalized goods and services to meet the demands of customers disappointed by the quality and genericism of supply. Artisans continue to craft furniture, stoneware, rugs, beers and wine, and a myriad other goods. Shortly following the industrial revolution came the reduction of agriculture as a major player in America’s gross domestic product in favor of industry. In today’s world, service has an outsized role in the American economy, seen mostly in information, financial, and managerial work from 2019 until 20212. Since the pandemic, remote work has given the standard W-2 employee the ability to work remotely thanks to technology. That same technology has empowered the small business owner to strike out on their own and use those efficiencies to be successful in their own ways.
The cottage industry hasn’t gone away, but shifted focus from agriculture and goods to services. With that came a real opportunity for these small businesses to grow profits, grow their employees, and ultimately contribute to the success of the American economy. Our government is interested in supporting successful business ventures by providing additional deductions as a resource to make that happen, and this includes the home office use deduction.
What is the Home Office Use Deduction and How Can I Use It?
This deduction is specifically geared toward the entrepreneur who solely operates business from their home – and only their home. This deduction cannot apply to the employed taxpayer who is allowed to work remote or hybrid schedules, nor should it apply for mixed use in a primary residence. If you work from your home, but also have a location where you can work, you won’t qualify for this deduction. A quick and dirty way to think about this is if you have a key to an office away from your home, this deduction won’t apply.
There are limits when taking the deductions. Overall, neither deduction can be more than the income generated from your business. If your business operates at a loss for the tax year, this deduction will not apply.
The purpose of this deduction is to take the designated space as an additional deduction, much like a mileage deduction, which can be used in tandem. There are two ways to calculate this deduction: Simplified and Regular method. Apply caution when taking this deduction on Form 8829. If you operate your business solely out of your primary home, be consistent in which method you apply or it will trigger an inquiry (audit) with the IRS.
Your home must be your primary residence where you spend the majority of the year living. Using a space in your home designated specifically for the function of your business is the purpose of taking the deduction. This could be your business’ own dedicated room, a portion of a garage used for inventory, a portion of your bedroom that you designate for your business, or a place to meet patients, customers, or clients for normal operation of your business3. Unless the room has a door and is designated for the work, it becomes somewhat challenging to prove the home office deduction for shared spaces. If you own a landscaping business and you use a detached building that’s part of your property where you store supplies and equipment, that building would easily count toward the home office use deduction.
Methods to Calculate Deduction
There are two methods to determine this deduction4. The simplified method is the easiest approach for any business owner because it has minimal recordkeeping and is the fastest to calculate. This is a great deduction for spaces that are 250 to 300 square feet in size. This deduction gives the business a $5/ft2 reduction in the dedicated space with a cap up to $1,500 (500 ft2).
The second method is the regular method. This requires the taxpayer to file Form 8829 and accounts for all direct and indirect expenses for the operation of the business use portion of the home. Let’s say, for example, that you own an engineering firm for stone quarries, and in your home, you have utilities like gas, water, electric, sewer, Netflix, and internet. On the home itself, you’re still paying mortgage interest, homeowners’ insurance, and biannual property taxes. Let’s say that you’ve have a business phone line installed and you needed to modify your office space with new flooring and electrical upgrades.
It may be immediately obvious to you, that as an engineer, the Netflix subscription is not a part of your normal business operation (not adding value to the end product) and therefore cannot be included in this calculation. But you have two categories of expenses that your business needs to function. Here, your direct expenses would be your business phone line and modifications to the office space including electrical upgrades. These expenses would be included at 100% toward your total deduction. But without your primary residence, there wouldn’t be a room to upgrade, so you have the other associated (indirect) expenses needed to retain the home you live and work from.
To address the indirect expenses, we need to apply a reasonable calculation to estimate the percentage of your utilities, interest payments, and taxes to your business deduction. For the sake of argument, and to reasonably justify the deduction, we will apply a ratio using the area. The square footage of your home is 2,500 ft2 and the dedicated space you use for business is 750 ft2. If you ratio the area used for your business over the total area of your home, in this case, you have 30% for business use. Next, you will obtain every paid invoice for every utility that you use in your office (electrical, gas, internet, mortgage interest, insurance, taxes). Sum the monthly totals in each category and apply the 30% ratio to determine the deduction on these expenses. You may then add this to the direct expense to get your final number.
You may also choose to ratio differently. For instance, you can use the number of rooms in your house against the number of rooms you dedicate to your business. You can choose as long as it’s consistent and a reasonable calculation.
Summing Up
There’s more to this story, but your tax professional is capable of asking the questions necessary to make this determination. If you qualify, the next inquiry is determining the method that gives you the best deduction, and if it’s easier for you to make the simplified over the regular calculation for recordkeeping purposes, you can select that method. As stated before, you will want to be consistent when using a method if you want to avoid making friends with IRS agents.
Tree City Tax is accepting new clients for the upcoming filing season, including small business returns. You can book a consultation by calling at (330) 539-4231. Small businesses that schedule a consult before the end of the year reduce their likelihood of filing an extension.
- Cottage Industry, Faisal Khan: https://faisalkhan.com/knowledge-center/payments-wiki/c/cottage-industry/
- The Rise in Remote Work Since the Pandemic and its Impact on Productivity, US Bureau of Labor Statistics: https://www.bls.gov/opub/btn/volume-13/remote-work-productivity.htm
- Eligibility for Business Use of Home Deductions, Belnavis Tax and Accounting Service: https://belnavisaccounting.com/business-use-of-home
- How Small Businesses Can Deduct Their Home Office From Their Taxes, IRS.gov: https://www.irs.gov/newsroom/how-small-business-owners-can-deduct-their-home-office-from-their-taxes