While the home office deduction is not the instant audit red flag it used to be, the rules surrounding it are strict. In this article, we show how to meet the two tests that the IRS uses to see if you can deduct your home office use: “exclusive and regular” and “principal place of business.” We also simplify each of the two methods for figuring the home office deduction: the expense method and the square footage method.
The key to safe use of the “business use of the home” tax deduction is being reasonable and following the rules. The IRS has had to change with the times. Home offices used to be rare, but 1 in 5 Americans now work at least a portion of their week at home and those numbers are growing rapidly. This means home offices don’t make taxpayers stand out to the IRS like they used to. As long as taxpayers follow the specific regulations for the home office deduction, they shouldn’t draw attention from the IRS.
To qualify as a home office for tax purposes, an office must be used “exclusively and regularly” for the business. It must also be “the principal place of business.” The IRS provides two methods for figuring a deduction for the business use of the home. Following the rules as they’re outlined below should keep taxpayers out of trouble.
Why Home Offices Have Traditionally Raised a Red Flag
According to the IRS, most unreported income comes from small businesses. An IRS document on “tests of unreported income” states that nearly $60 billion per year in tax revenue goes unreported by sole proprietors and other very small, one-person businesses. One of the few indicators the IRS cites in this document as a predictor of unreported income is whether the taxpayer has claimed a “questionable” business use of their home.
Business Use of Home: How to do it Right
Deciding if someone can take the home office deduction boils down to whether the home office was used “exclusively and regularly as the principle place of business.”
Home Office Test #1: Exclusive Use
The IRS requires anyone claiming their home as a business deduction to use their home office “exclusively and regularly.” A home office can be three rooms in a home, one room or even a portion of a room, as long as there’s a clear separation between the office and the non-work section of the room.
In the case of a room with a spare bed in it and a desk, only the portion of the office that contains the desk can be claimed, and only if the desk is used only for conducting business — nothing else. But the IRS is strict about that “nothing else” designation. If children occasionally use the desk for doing homework, or a spouse sits there and surfs the internet at night or it doubles as a changing table for the baby all day, the office fails the exclusivity test.
Does that mean that if a woman has a home office and a friend calls to discuss dinner plans, she has to leave to take the call? No. According to TurboTax, a home office should be thought of like a regular office. Some offices allow the odd personal call or peek at facebook. As long as personal use is kept to the same levels as in a “regular” office, the IRS will generally allow it.
Home Office Test #2: Principal Place of Business
Someone who works from home doesn’t have to work 10 hours a day to pass the “principal place of business test.” For example, consider a woman who works at Lowes full time but has three rental properties. She uses her home office only one hour a day to manage her rentals. However, she uses the office exclusively to manage these three properties. In other words, she has no other office where she does administrative tasks for her rental business. Therefore, for that business, even though she only works in her home office one hour a day, it’s still her “principal place of business.”
What about an electrician who spends ten hours a day at clients’ houses performing installations and repairs, and one hour a day in the home office on administrative tasks? His home office is still considered the primary place of business. He can still take the home office deduction as long as there’s no other fixed location where he conducts regular, significant administrative tasks.
Someone who works at a regular office most days and only occasionally at home won’t qualify for the home office deduction. A man who works three days at the company’s office downtown and two days from home can’t claim the home office deduction.
While his home office may be used only to conduct business, it’s not his principal place of business. That’s because his company provides a workplace where he spends most of his working hours.
The one exception in Pete’s case is if he works at home not for his own convenience, but to help out his boss. For example, if Pete’s boss needs him to work at home two days a week to save on utility costs, Pete can claim his home office on his taxes.
Business Use of Home: How to Stay Legal
Once the “exclusive use” and “primary place of business” tests have been met, there are two methods by which home office expenses can be deducted:
Home Office Method #1
Method #1 for figuring the home office deduction is the old fashioned way. IRS regulations state that 100% of expenses incurred entirely in service of the business can be deducted. These are called “direct expenses,” and include things like land lines used only for the business or expenses to remodel the home office to make it more presentable for visiting clients. The rest are called “indirect expenses,” and can include utilities that benefit the entire home like heat, electricity and water, as well as rent, insurance, repairs and maintenance.
Only a portion of these indirect expenses may be deducted. The amount is figured by first measuring the square footage of the home, then measuring the area used exclusively as the primary place of business. The percentage of the home used as an office is then multiplied by each indirect expense to figure the deduction.
For example, imagine someone named Angela whose home is 1,700 square feet. Her office is 100 square feet. It is her primary place of business, and it’s not used for anything except for business. Since 100 is 6% of 1,700, Angela will claim 6% of all her indirect expenses.
These rules and calculations are explained in detail in IRS form 8829 and its instructions. Alternatively, tax software like TaxACT, TurboTax and H&R Block Online can handle the math and remove all confusion.
Home Office Method #2
In 2013, the IRS introduced a new, simpler way of figuring the home office deduction. Taxpayers multiply the square footage of their home office by $5, and claim the result as their deduction. The maximum allowable deduction with this method is capped at $1500, and the maximum square footage for the home office is limited to 300 square feet. The new method also disallows claiming depreciation on the home. It’s a good idea to check both methods to see if one of them provides a bigger refund.
The Bottom Line
The Home Office Deduction is not as scary as it used it be. While in the past it may have been a big red flag to the IRS, with more people working from home all the time the danger surrounding the deduction continues to dwindle. As long as taxpayers follow the IRS rules for claiming the deduction, business use of the home provides a safe and welcome tax break.
- Predictors of Unreported Income – IRS Bulletin
- Home Office Deduction – IRS Publication
- IRS Form 8829
- IRS Form 8829 Instructions