The Home Office Deduction: Rules, Methods, and Common Mistakes

The home office deduction has an outsized reputation for audit risk that is not entirely deserved. It is a legitimate deduction with clear requirements. Problems arise when owners claim it without meeting the requirements or without records.

Who can claim it

Self-employed taxpayers, such as sole proprietors and owners of single-member LLCs reporting on Schedule C, and partners in some circumstances, can claim a deduction for the business use of part of their home if the requirements are met. Employees generally cannot claim the deduction on their personal returns under current federal law, which suspended miscellaneous itemized deductions for unreimbursed employee expenses. That includes owners who are W-2 employees of their own S-corp or C-corp. For them, the corporation can reimburse home office costs under an accountable plan. See accountable plan guide.

The requirements

The space must be used:

1. Regularly. Not occasionally or incidentally.
2. Exclusively for business. A room used for business and also as a guest room or family space fails, with limited exceptions (such as daycare providers and certain storage of inventory).
3. As the principal place of business or as a place where you meet clients or customers in the normal course of business, or as a separate structure used for business.

A home office qualifies as the principal place of business if it is used for administrative or management activities and there is no other fixed location where the taxpayer conducts substantial administrative or management activities. So a self-employed person who delivers services at client sites but does billing, scheduling, and planning from a home office can generally qualify.

The space does not have to be a room. It can be a defined area, but it must be used exclusively for business. A desk in the corner of a living room used only for work can qualify, though it is harder to prove.

Two methods

Simplified method. Deduct a standard rate per square foot of the home office, up to a maximum of 300 square feet. The rate has been $5 per square foot, for a maximum of $1,500. There is no need to calculate actual expenses or depreciation. You still need to qualify under the use tests and keep records of square footage. The deduction is limited to your gross income from the business.

Actual expense method. Deduct the business percentage of home costs. Calculate the percentage as office square footage divided by total home square footage (or by number of rooms if rooms are of equal size). Apply it to:

• Rent, or mortgage interest and real estate taxes.
• Utilities.
• Homeowners or renters insurance.
• Repairs and maintenance affecting the whole home.
• Depreciation on the business portion of a home you own.
• Cleaning and other allocable costs.

Direct expenses (for example, painting only the office) are fully deductible, while indirect expenses are allocated by percentage. Actual expenses require more records. The deduction is generally limited by business income, and excess amounts carry over to future years.

Which method is better

The simplified method is easier and avoids depreciation and its later recapture consequences when you sell the home. The actual method can produce a larger deduction if your home costs are high or your office is large. Consider running both for a year. You can switch methods from year to year, with some restrictions related to depreciation.

Depreciation and home sale considerations

If you use the actual expense method and claim depreciation on the home office, you must account for it when you sell the home. The gain exclusion for a primary residence does not cover depreciation taken after May 1997, which is taxed (as unrecaptured section 1250 gain, at a maximum federal rate of 25 percent). The simplified method has no depreciation, so no recapture. Consult a professional before selling.

Records to keep

• A floor plan or measurements showing the office and total home square footage.
• Photos of the space showing the exclusive business use.
• Bills and statements for rent, mortgage interest, taxes, utilities, and insurance.
• A calendar or log supporting regular use, if you use the space for meetings.
• Documentation of any direct expenses.

Interaction with other rules

• Home office and vehicle deductions. A qualifying home office as principal place of business can make trips from home to clients deductible business travel rather than commuting. See vehicle deductions.
• Self-employment tax and QBI. The deduction reduces net profit, which lowers self-employment tax and affects the QBI deduction.
• Renting your home to your business. Some owners consider having an S-corp rent part of their home. The rent is income to you, and the arrangement must be at reasonable rates and supported. There are special rules about renting a home to your employer, and tax benefits may be limited. Get advice.
• Employees who work from home can be reimbursed under an accountable plan.

Common mistakes

1. Claiming the deduction for a room that is also used personally.
2. Using the entire home as the base rather than a measured percentage.
3. Claiming the deduction as an S-corp owner on the personal return.
4. Deducting expenses without records.
5. Ignoring the income limitation and the carryover of disallowed amounts.
6. Claiming both the simplified method and actual costs in the same year.
7. Ignoring depreciation recapture when selling.
8. Overstating square footage.

Renters and homeowners

Renters can deduct their share of rent and utilities. Homeowners can deduct the share of mortgage interest, real estate taxes, insurance, utilities, and depreciation. Note that the business share of mortgage interest and real estate taxes would otherwise be itemized deductions, so the office deduction may reduce the benefit of itemizing, but it does not change the total deduction you can take for those items.

Working with a co-working space or office

If you rent an outside office, the rent is a business expense without the home office tests. Do not use both an outside office and a home office for the same activity without carefully considering whether the home office still qualifies as the principal place of business.

If you would like help deciding between methods or structuring a reimbursement for an S-corp, AE Tax Advisors can assist, and a discovery call is a simple start.