Calculating Your Home Office Deduction
Working from home is more common than ever, and the home office deduction helps lower your net income and reduce your tax liability—if you qualify for it. The home office deduction trips up many tax filers, though, and you have questions. What can you include in the deduction? How do you calculate it? Where do you report it? It’s a lot to sort through—we get it. That’s why we’re here to help. Today we’ll cover the dos and don’ts of the home office deduction so you’ll be ready to file in time for tax day.
What’s Included in the Home Office Deduction
For a space to count as a home office, the area must be related to regular and exclusive business use. Any associated costs must be clearly distinguishable from personal use, or you must be able to divide the cost between personal and business use.
Let’s clarify two points here: “Regular use” means used on a regular basis. Occasional use or nonessential use doesn’t qualify. “Exclusive use” means you use your home office only for your rental property business. You must meet both conditions to deduct a home office.
If you meet the conditions, the next step is to gather the information related to your office space and home. You’re able to deduct a portion of costs that normally either wouldn’t be deductible or would be taken on Schedule A if you itemize. You can deduct the business-related portion of:
• depreciation
• insurance
• mortgage interest
• painting
• real estate taxes
• rent
• repairs
• security systems
• utilities
Remember, though, that personal, family, and living expenses are not deductible here. One common error is deducting expenses for an area that isn’t used regularly or only for business. The home office deduction can act as a red flag for the IRS, so if you choose to take the deduction, make sure your supporting documentation is in order.
How to Calculate the Home Office Deduction
The IRS gives us two options for calculating the home office deduction. Note that no matter which method you use this year, you’re free to use the other next year.
The Actual-Expense Method
For the actual-expense method, you start by determining what percentage of your home you use for business. Then you’ll divide your costs between personal and business use. There may be some overlap between the two, and that’s ok. That’s where your business-percentage allocation comes in. Classify your costs into three categories.
1. Direct—these outlays are entirely for the office space. They’re 100% deductible. If you made a repair in the office area, the entire amount is deductible.
2. Indirect—these outlays are divided between personal and business use. Think about costs that cover your entire home, such as utilities, depreciation, or insurance. You’ll deduct only the business-related percentage of the cost.
3. Unrelated—these payments are not related to the business. Expenditures like lawn care or other personal costs aren’t deductible.
The best practice here is to take a picture of your home office and document how you calculated the square footage of your space.
Now, the IRS has limits on how much you can deduct. Your home office deduction cannot cause your business to have a net loss. So if your Schedule E income is $1,500 and your home office deduction is $1,700, you can only deduct the $1,500. You don’t lose the remaining $200, though. You’ll suspend it to use in future years when you have net income. (See IRS Publication 587 for more details.)
The Simplified Method
For the simplified method, you start by determining the square footage of your home that you use for business. Then you multiply the qualified business area by $5. That’s it.
The simplified method is easier, but it comes with a few downsides.
• The IRS limits the qualified business area to 300 square feet, so the maximum deduction is $1,500.
• If you used the actual expense method last year and you have a suspended amount, you can’t take that amount if you use the simplified method this year.
• Depreciation and actual expenses aren’t deductible.
• Section 179 costs aren’t deductible for home office spaces.
It is entirely possible that you’ll have more of a deduction from using the actual-expense method. You’ll have to decide whether the additional hassle of calculations and supporting documentation is worth it for you.
Again, no matter which method you use, this deduction is a focus area for the IRS. Document your calculations, and keep your supporting records. (Think it may be time to clear out old files? Check out our article on file retention.)
Calculating Depreciation for Your Home Office
With our personal dwellings, we usually can’t deduct depreciation on our tax returns. But when you have a home office for your rental property business, you may deduct depreciation related to the office space. It’s a multistep calculation, but you’ll only need to do it once. For full instructions on how to calculate depreciation for your home, see our article Calculating Basis & Depreciation for Personal Properties Put into Service.
Once you have your home’s annual depreciation calculated, it’s time to determine the portion associated with your home office. Here’s the formula:
Square footage of your office space ÷ Total square footage of your home = Business percentage
Then multiply your annual depreciation figure by your business percentage. That’s your home office depreciation expense for the year.
Where to Deduct Your Home Office Expenses
It’s true—the Schedule E doesn’t have a line just for the home office deduction. That throws off many people. But don’t worry. That’s why we have line 19. It’s the spot to report any ordinary and necessary expenditures not listed on lines 5 through 18.
If you use Schedule C, you’ll need Form 8825 to calculate and report your deduction.
Takeaways
The home office deduction helps rental property owners lower their net incomes and reduce their tax liabilities. The key step is making sure you qualify for the deduction in the first place. After that, you choose between the actual expense method and the simplified method to calculate your deduction. As your situation changes from year to year, one method may be more beneficial than the other. If you aren’t sure if you qualify, or which calculation method is best for you, talk with your CPA. Just remember that documentation is critical. That’s why REI Hub has built-in receipt and document storage. We designed our software for you, with expense tracking and reports preconfigured for real estate investors. Try a risk-free trial and see why our customers consistently give us 5-star reviews.
