These days, a large number of workers do their jobs out of their homes. And it's those people who may be eligible for home office deductions. Here, we'll review how the home office deduction works, who's eligible for it, and how to claim it.
How tax deductions work
Before we dive into the home office deduction itself, it's important to explain how deductions actually serve as a tax break. When you claim a deduction on your tax return, the amount of that deduction is excluded from taxes. As such, you're not saving the amount you claim but, rather, you're making it so that portion of your income isn't taxed by the IRS.
For example, if you claim a $2,000 deduction, that's $2,000 of earnings that don't count for tax purposes. Your actual savings from that deduction will then be a function of your specific tax bracket, which indicates how much tax you pay on your highest dollars of earnings. If you fall into the 24% tax bracket, a $2,000 tax deduction gives you $480 in actual savings.
Now that that's clear, let's discuss how the home office deduction works.
Who can claim the home office deduction?
In order to claim the deduction, you must be classified as self-employed. If you're a salaried employee who works from home, you, unfortunately, don't qualify.
Note that this wasn't always the case. Prior to the Tax Cuts and Jobs Act of 2017, salaried employees who did their jobs from home could write off the cost of maintaining a home office under the miscellaneous itemized deductions allowance, which allowed workers to deduct costs exceeding 2% of their adjusted gross income. But since tax reform eliminated miscellaneous itemized deductions, employees of another company can't claim a home office.
Now if you are self-employed, there are still criteria you'll need to meet to take a deduction for your home office:
- Exclusive use: To claim a home office deduction, you must have dedicated space in your home used solely for business purposes. For example, if you have a room with a desk, cabinets, and computer equipment that you do your job from, that counts. If you have a large, finished basement, half of which is sectioned off with a similar setup for business use, that counts, too.
What doesn't count, however, is setting up your laptop on your dining room table and claiming that space is your home office. Clearly, it has more than one use -- it's a place for your family to eat. The same holds true if you stick a small desk in the corner of your children's playroom. Because that space isn't used exclusively for business purposes, it doesn't count as a home office for tax purposes.
- Principal place of business: To claim a home office deduction, the space in your home that you work from must constitute your principal or primary place of business. If you rent a co-working space in town that you see clients at three to four days a week, and you generally use your home office just once or twice a week, that doesn't count.
Keep in mind that if you meet the above criteria, you can claim a home office deduction whether you're a homeowner or a renter. And, you can claim it if you work out of a structure that's adjacent to your home but not part of it, like a detached garage.
How to calculate your home office deduction
Once you determine that you're eligible for the home office deduction, the tricky part becomes figuring out its value. To this end, there are two methods you can use:
- The simplified method: With the simplified method, you can claim a $5 deduction per square foot of your home office, up to 300 square feet. Under this method, your deduction maxes out at $1,500. The upside of the simplified method is that it's easy to calculate. But in some cases, it won't constitute the most lucrative tax break.
- Deducting actual expenses: With this method, you deduct the actual cost of the business expenses you encounter in the course of working out of your home. There are two types of expenses you can deduct:
- Direct expenses
- Indirect expenses
Direct expenses are those that related specifically to business activities. For example, if you repaint your home office or buy furniture for it, you can claim those costs on your tax return in full.
Indirect expenses are those related to the cost of owning or living in your home. They include mortgage interest, real estate taxes, homeowners insurance, home maintenance and repairs, and utilities. To claim your indirect expenses, you'll need to total them up and see what percentage of your home your office entails.
For example, let's say you spend $20,000 over the course of a year on mortgage interest, property taxes, insurance, upkeep, and utilities. If you live in a 2,000-square-foot home, and your home office takes up 200 square feet of it, then you get to deduct 10% of your indirect expenses -- in this case, $2,000.
Will the home office deduction increase your audit risk?
Some people fear that claiming a home office deduction will raise a red flag for the IRS. But if your deduction is both reasonable and legitimate, that shouldn't be an issue.
What does "reasonable" mean? The IRS is generally wary of deductions that seem disproportionate to the amount of income being reported. For example, if your home office deduction amounts to $15,000 and you only report $30,000 of income, that may look suspicious. But claiming a $15,000 home office deduction (keeping in mind that that figure may include direct expenses that allow you to do business) against an $80,000 income shouldn't seem out of line.
That said, if you're going to claim a home office deduction, make sure you're not only eligible but that you have detailed records of the expenses related to it (unless, of course, you use the simplified method to calculate your deduction, in which case you won't need to go into that level of detail). Retain scanned copies of receipts for purchases you make during the year, including:
- Office furniture
- Office equipment
- Office supplies.
And keep detailed records of expenses, including:
- Utility bills
- Property tax payments
- Payments to contractors who fix your home or keep it standing
That way, if the IRS does decide to question your tax return, you'll have a means of backing up your claim.
The home office deduction could put a lot of money back in your pocket. Follow the rules around it carefully, and with any luck, you'll score a lucrative tax break in the course of working from home.