Article Highlights: Qualifications Actual Expense Method Simplified Method Home Office Expenses for Renters vs. Homeowners Deduction Limitation How Moving Affects the Home-Office Deduction Other Issues If you are a small business owner and use part of your home for business, you may be able to take the so-called office-in-home tax deduction. This deduction reduces both income and self-employment taxes. While the term “home office” is used to describe when a taxpayer uses their home for a business purpose, the space used may not be an office but may still qualify for the deduction. One of the following must apply for you to be able to deduct home office expenses. The home office: Must be your main place of business. OR Must be a place of business where, in the normal course of your business, you meet patients, clients or customers (just telephone contact with clients isn’t enough to meet this test). OR Must be in a separate structure that is not attached to your home, and you use it in connection with your business. OR Must be a place where you store inventory or samples. This place must be the sole, fixed location of your business. OR Under certain circumstances, must be where you provide day-care services. Generally, except when used to store inventory, an office area must be used on a regular and continuing basis and be exclusively restricted to the trade or business (i.e., no personal use). Two Methods – There are two methods to determine the amount of a home-office deduction: the actual-expense method and the simplified method. Actual-Expense Method – The actual-expense method prorates home expenses based on the portion of the home that qualifies as a home office, which is generally based on square footage. The non-business portions of home mortgage interest and real property taxes continue to be deductible on Schedule A if you itemize deductions. Aside from prorated expenses, 100% of directly related costs, such as painting and repair expenses specific to the office, can be deducted. Unlike the simplified method (discussed next), the business-use part of the home is not limited to 300 square feet. Simplified Method – The simplified method allows for a deduction equal to $5 per square foot of the home used for business, up to a maximum of 300 square feet, resulting in a maximum simplified deduction of $1,500. You may elect to take the simplified method or the actual-expense method (also referred to as the regular method) on an annual basis. Thus, you may freely switch between the two methods each year. Additional office expenses such as utilities, insurance, office maintenance, etc., are not allowed when the simplified method is used. Prorated rent or home interest and taxes are not additionally deductible either, although 100% of home interest and taxes, within the normal Schedule A limitations, are deductible if you itemize deductions. To determine the average square footage when using the simplified method, no more than 300 square feet for any month can ever be used, even if you have multiple businesses for which you use space in your home. If there are multiple businesses, a reasonable method to allocate between businesses is used. Zero is used for months when there was no business use or when the business was not operating for a full year. Don’t count any month when the business use was less than 15 days. Example: Sandra begins using 400 square feet of her home for business on July 20, 2022, and continues using the space as a home office through the end of the year. Her average monthly allowable square footage for 2022 is 125 square feet (300 x 5 months = 1,500/12 = 125). Home Office Expenses – There are differences as to which prorated home expenses are deductible by renters and homeowners when computing the actual expense method, as illustrated in the table below. Prorated Expense Own Rent Mortgage Interest X Property Tax X Rent or Lease Payments X Homeowner's Insurance X Renter's Insurance X Utilities X X Depreciation X Home Maintenance X X Note that the principal payments made on a home loan are not eligible expenses. Instead, homeowners claim a deduction for depreciation on the office portion of the home’s basis. Home Office Deduction Limitation – Even if you qualify for a home-office deduction, your deduction is limited to the business activity’s gross income, which for this purpose is defined as the activity’s gross income, reduced by the home expenses that would be deductible if there were no business use (e.g., mortgage interest, property taxes, certain casualty losses), and the business expenses unrelated to the home’s use. When using the actual expense method, the disallowed amount will be carried over to the next year subject to the same limitations. However, there’s no carryover when using the simplified method. Example: Let’s say you use 20% of your home for business, have gross income of $6,000 from the business and have the following expenses: Deductible mortgage interest (20%) $1,500 Real estate taxes (20%) $1,000 Total $2,500 Expenses not related to business use of the home (100%): Supplies $500 Advertising $1,300 Telephone $200 Total $2,000 Otherwise, nondeductible expenses: Home Maintenance (20%) $200 Home Utilities (20%) $350 Home Insurance (20%) $250 Total. $800 Depreciation (20%) $1,600 Based on the above expenses, you figure your deduction limit as follows. Gross income $6,000 Less: Deductible mortgage interest (20%) $1,500 Real estate taxes (20%) $1,000 Expenses not related to business use of the home (100%) $2,000 Total $4,500 Deduction limit $1,500