Key Rules for Home Office Deductions

Do you work from home all or part of the time? If you're self-employed and meet certain requirements, you can write off a portion of your home office expenses, even if you perform work at other locations. The deduction may be based on the actual expenses you're able to substantiate—or it may be computed using a simplified method approved by the IRS. 

The Basics

Generally speaking, self-employed individuals are eligible for home office deductions if part of their homes are used "regularly and exclusively" as their principal place of business or a place to meet or deal with customers, clients or patients in the normal course of business. In addition, they may be entitled to take deductions for an area used to store products or tools for a business. They also may be able to deduct the costs associated with a separate structure—such as a detached garage or shed—that's used strictly for storage or other business purposes.

Important: Under current law, employees currently can't deduct unreimbursed business expenses, including home office expenses. (See "Will Opportunity Knock Again?" below.)

To qualify for the deduction, you must meet the following two tests:

1. Regular use test. You must use a specific area of your home for business on a regular basis. Incidental or occasional business use isn't regular use.
2. Exclusive use test. You must use a specific area of your home exclusively for business. This area can be either a room or other separately identifiable space. It's not necessary for the space to be physically partitioned off from the rest of the room. However, you don't meet the requirements for the exclusive use test if you use the area both personally and for business.

Another potential obstacle is that the home office must be your "principal place of business." The IRS may challenge home office deductions if you work at multiple locations, for instance, at your customers' homes or offices.

Nevertheless, your home office qualifies as your principal place of business if it's used regularly and exclusively for administrative activities, such as invoicing and managing accounts, and you don't have any other fixed location for conducting these activities. This often provides an opportunity for taxpayers in a wide range of industries, including physicians, plumbers, freelance writers and landscapers.

Which Door to Go Through?

To claim home office deductions on your 2023 return, you can choose either of the following methods:

Actual expense method. Under this method, you write off the full amount of your direct expenses and a proportionate amount of your indirect expenses based on the percentage of business use of the home. 

For example, Marta used a room comprising 10% of her 3,000-square-foot home as an office for her interior design business in 2023. She spent $5,000 to have the home office painted and carpeted. She also incurred another $10,000 in indirect expenses for the entire home. She meets the requirements for a deductible home office. Under the actual expense method, Marta can deduct $6,000 ($5,000 plus 10% of $10,000) of home office expenses on her 2023 federal income tax return. 

Examples of indirect expenses include:

• Mortgage interest,
• Property taxes,
• Gas, electric, water and other utilities,
• Insurance,
• Home security system costs, and
• Depreciation or rent under IRS tables.

Mortgage interest and property taxes might already be deductible if you itemize deductions on your personal return. If an itemizer claims a portion of these expenses as indirect home office expenses, the remainder is deductible, but you can't deduct the same expenses twice.

Typically, the percentage of business use is determined by the square footage of your home office. For instance, if you have a 3,000-square-foot home and use a room with 300 square feet as your home office, the applicable percentage is 10%. Alternatively, you may use any other reasonable method for determining this percentage. For instance, you might use a percentage based on the number of rooms of comparable size in the home.

Simplified method. Instead of tracking all your actual expenses, this method allows you to claim a deduction equal to $5 per square foot for the area used as a home office, up to a maximum of $1,500 for the year. This is much easier than gathering all the records required for deducting actual expenses.

Clearly, the simplified method is more convenient to use. But the actual expense method generally produces a bigger overall deduction.

For example, in the hypothetical scenario above, Marta could claim a home office deduction of only $1,500 for 2023 using the simplified method (the lesser of $1,500 or $5 times 300 square feet). That's $4,500 less than under the actual expense method.

Important: Once you select a method, you're not locked into using it for all tax years. For instance, you might choose the actual expense method for 2023, then switch to the simplified method for 2024.

Beware of a Potential Tax Trap

There's one additional tax wrinkle to consider if you claim home office deductions. If you eventually sell your principal residence, you may qualify for a tax exclusion of up to $250,000 of gain for single filers ($500,000 for married couples who file jointly). However, if you use the actual expense method, you're required to "recapture" the depreciation attributable to a home office for the period beginning after May 6, 1997. To compound the problem, the recaptured amount is taxable at a 25% rate. That's higher than the maximum long-term capital gains tax rate of 20%.

To make matters worse, the recapture provision technically applies to "allowed" or "allowable" depreciation. That means it's imposed on a home sale even if you don't claim depreciation on your return. If you claim home office deductions over several years, the tax liability can quickly add up. Conversely, if you haven't previously deducted home office expenses and plan to claim the deduction going forward, you might forgo a deduction based on actual expenses.

Important: The recapture rule doesn't apply if you use the simplified method for deducting home office expenses. This may be another good reason to stick with the simplified method when claiming a home office deduction.

Will Opportunity Knock Again?

Before the Tax Cuts and Jobs Act (TCJA) went into effect in 2018, an employee could deduct out-of-pocket home office expenses as miscellaneous itemized expenses on his or her return, subject to an overall floor of 2% of adjusted gross income. However, to qualify for this deduction under the prior rules, the home office needed to be required as a condition of employment for the employer's convenience.

Unfortunately, the TCJA suspended miscellaneous expense deductions from 2018 through 2025. The miscellaneous expense deduction is scheduled to return in 2026, unless Congress passes legislation to revive it sooner. Conversely, Congress may decide to make the ban permanent.

Unlock Your Deduction

The home office deduction can be a valuable tax-saving opportunity for many self-employed taxpayers. Just keep in mind that when you sell your house, there may be tax implications if you have claimed a home office. Consult with your SSB tax advisor to determine what's right for your situation.

©  2024