Home Office Expense

The Home Office Deduction allows eligible taxpayers who use a portion of their home for business purposes to deduct related expenses from their taxable income. This deduction is particularly relevant for self-employed taxpayers.  The Tax Cut and Jobs Act passed in 2017 eliminated the federal home office deduction for employees (including remote workers) who work from home.  However, some states, including California, did not conform to that federal law change, so employees who as a condition of their employment work from home and meet the other requirements can take the deduction as an itemized deduction on their state return.

Eligibility Criteria

To qualify for the home office deduction, taxpayers must meet specific requirements set by the Internal Revenue Service (IRS):

1. Exclusive and Regular Use: The part of the home used for business must be used exclusively and regularly for business activities. This means that the space cannot be used for both business and personal purposes.

2. Principal Place of Business: The home office must be the principal place of business for the taxpayer. Alternatively, if the taxpayer conducts business outside of the home, the home office must be used regularly for administrative or management activities and there must be no other fixed location where these activities are substantially conducted.

3. Employee Use for eligible state returns: Employees claiming the home office deduction on their state return must use the home office for the convenience of their employer. Additionally, the employee must not rent any part of their home to the employer and use the rented space to perform services as an employee for the employer.  Each state can have its own unique requirements for deductibility, so be sure to research the topic carefully on your state's webpage.

Calculation Methods

The IRS offers two methods for calculating the home office deduction: the Regular Method and the Simplified Method.

1. Regular Method: This method involves calculating the actual expenses of maintaining the home office. Expenses can be categorized into direct and indirect expenses.

   Direct expenses are those specifically related to the home office, such as painting, electrical repairs, security devices, and so forth. Indirect expenses are those that benefit the entire home, such as mortgage interest, property taxes, utilities, homeowner association fees, homeowner' insurance, security systems, and so on. These expenses are prorated based on the percentage of the home used for business.

   • Calculation Example:
     • Determine the percentage of the home used for business by dividing the area of the home office by the total area of the home.  Exclude the square footage of any attached garage.
     • Apply this percentage to the total allowable indirect expenses.
     • Add any direct expenses to the prorated indirect expenses to get the total deduction amount.

2. Simplified Method: Introduced in 2013, this method allows taxpayers to deduct $5 per square foot of the home office, up to a maximum of 300 square feet. This method simplifies record-keeping as taxpayers do not need to track actual expenses.  Just be aware that for most taxpayers, this method produces a significantly lower deduction.

   • Calculation Example:
     • Measure the square footage of the home office space.
     • Multiply the square footage by $5.
     • The maximum deduction using this method is $1,500 (300 square feet x $5).

Record-Keeping Requirements

Proper record-keeping is essential for substantiating the home office deduction. Taxpayers should maintain records that clearly show the allocation of business and personal use of the home. Important documents include:

• A floor plan showing the dimensions of the home and the home office.
• Receipts and invoices for direct expenses related to the home office.
• Utility bills, mortgage statements, and insurance bills to substantiate indirect expenses.
• A detailed log or calendar of business activities conducted in the home office.
• Pictures of the home office showing the layout and its contents.  Remember that you could move after filing the return and before being notified of an audit.  In that circumstance, the Agent cannot visit your home office to verify its qualification.  So, pictures showing the details of the home office could belp avoid the loss of the deduction.

Limitation relating to Net Profit

Your deduction is limited to the net profit of the business.  In other words, if the net profit for the year was $2,000 (gross receipts less expenses), and your home office deducton was $2,500, you can only deduct $2,000 as a home office deduction, and the unused balance ($500 in this example) can be carried over to the next year and used to reduce your net income in that year - assuming you have sufficient net profit in that year to absorb it. 

Common Misconceptions and Pitfalls

Several misconceptions can lead to incorrect claims or denial of the home office deduction:

1. Dual-Use Space: Many taxpayers mistakenly believe that a space used for both personal and business purposes qualifies for the deduction. However, the IRS requires exclusive business use.  If you have a large room and plan to only use a portion of it for your business, you must put dividers in place to clearly differential the home office space from the personal space.  

2. Minimal Use: Occasional or minimal use of a home office does not meet the "regular use" criterion. The space must be used consistently and substantially for business activities. 

3. Employees Working from Home  (State returns): Employees must prove that their home office use is for the convenience of their employer, not just for personal convenience.

Other Considerations

Many cities have regulations that require homeowners to apply for a license or permit to operate a business out of their home.  The penalty for not having the license can be significant.  Many cities have access to State tax information wherein the can identify taxpayes who have business schedules on their returns with a home address for which there is no license or permit on file.  Los Angeles is one example of a city that uses the CA returns of its residents to identify non-compliant residents. 

In addition, many homeowner insurance policies require disclosure if the residence will have clients or customers coming onto the property for business purposes.  If a client or customer were hurt while on your property, and you did not advise your insurance carrier that part of your residence was being used for business, you may not be covered for any damages the client or customer may seek.  So, if you are going to conduct business from your home and expect clients or customers to visit your home, be sure to touch base with your insurance carrier for any endorsement that may be required for your policy. 

Conclusion

The federal Home Office Deduction provides significant tax savings for eligible taxpayers. By understanding the eligibility criteria, choosing the appropriate calculation method, and maintaining meticulous records, taxpayers can effectively leverage this deduction. As the trend towards self-employment continues to grow, the home office deduction will remain an important aspect of tax planning for many individuals.

Updated: 6/23//24