The IRS permits self-employed individuals and some employees who work out of their home to deduct business expenses relating to the part of their home that is used for business purposes. The IRS has two ways you can deduct these expenses - you can choose between a Simplified Method or an Actual-Cost Method, similar to the Auto Expense Deduction. Each tax year you can choose which method will work best for you - unlike with auto expenses which forces you to stick with the method you chose initially.
However, before you can claim the home office deduction you must meet two major requirements:
- Regular and Exclusive Use - Regularly means you use it often - not necessarily every day, but occasional or incidental use doesn't qualify, even if the room is used solely for business. Exclusively means that you must use the space you designate as your home office for work only - any non-business usage of the room will disqualify the home office deduction.
- Principal Place of Business - The second requirement is that your home office be used either as a place of business to meet with clients, customers or patients in the normal course of business or as your administrative office where you pay bills, set appointments, and invoice customers.
Now, let's discuss the differences between the two methods...
Simplified Home Office Deduction
With the simplified deduction, you will not calculate your deduction based on actual expenses, instead you multiply the square footage of your home office by $5 (for 2013-2014). The maximum footage for this method is 300 square feet, limiting your deduction to $1,500 each year. So, if you have a 200 square feet home office, your home office deduction will be $1,000 (200 x $5).
You will still be able to deduct other qualified home expenses, such as mortgage interest and property taxes in full on Schedule A. You are not able to deduct depreciation on the business portion of the home. Also, if using this method and it causes a loss from the related business, the loss may not be carried over to future years.
Actual Expense Method
With the actual expense method, deductions for your home office are based on the percentage of your home devoted to business use. Deductible expenses can include mortgage interest, insurance, utilities, repairs, and depreciation. This method requires quite a bit more record keeping and cost allocation, but could result in quite a bit of tax savings.
If using the Actual-Cost Method and claiming depreciation, you will need to watch out for depreciation recapture when it comes time to sell the residence. The gain on the amount depreciated will be taxed up to 25%.
Should I Use the Simplified Method or Actual-Cost Method?
While each individual case is different, there are some situations where it will almost always be beneficial to use one method over the other.
When to Use the Simplified Method:
- If the cost of your home is less than $200,000;
- If you have a low marginal tax rate.
- If you are a renter.
When to Use the Actual-Cost Method:
- When the cost of your home is more than $300,000;
- If you have a high marginal tax rate;
- If your office space is more than 300 square feet;
- If there has been an increase in the amount of repairs to the residence during the year;
- If you will be reporting a loss.
If the cost of your home is between $200,000-$300,000 the best option will depend on your marginal tax rate and the business use percentage.
As I mentioned, each case is different and there is no one-size-fits-all when it comes to anything related to taxes. I recommend record-keeping as if you are going to use the Actual-Cost Method, then it when it comes tax time we can decide which option is best.