With more and more people working from home, we are often asked how the home office deduction works and what qualifies for it. For definition purposes, the home office deduction is a tax benefit that allows a business owner to deduct a portion of their household expenses that can be reasonably allocated to a dedicated office space. How the home office deduction is taken depends on a variety of factors, including the type of business (sole proprietorship, s-corporation, or partnership).

A few rules apply no matter the nature of the business entity, including:

• You must calculate the percentage of your home that is dedicated to your office. This is done by dividing the square footage of your office space by the square footage of your entire home.

• The home office area must be a dedicated area used only for business, with two exceptions.

  • It is used for day care services provided to children, seniors (65 or above) or disabled individuals.

  • The space is used for inventory or product samples sold by the business.

• Your home office must be your principal place of business. Although office space may be available elsewhere, your home office must be the primary place where administrative or management activities are regularly conducted. It is important that your home office is the nerve center of the business, not just a convenience.

• W-2 employees who work from home are not allowed to take the home office deduction for work conducted for their employer.

• The eligible deductions for home office usually include a pro rata (dividing something based on a proportion or percentage) allocation of all utilities used in the home office area, internet, trash, mortgage interest expense, HOA fees, property taxes, and home insurance. Repairs and maintenance may also be included, if it benefitted the space used for your office, but remember you can only deduct the percentage of the service that applied to your office.

  • Repair or use example: You can fully deduct electrical work done to accommodate equipment used in your home office. You can also deduct direct expenses of the home office in full, such as  painting your home office, adding a secondary dedicated phone line, or purchasing office furniture.

  • Maintenance example: You can deduct a percentage of a maid service that cleans your whole house, including your office, however, a pool service would generally not be allowed. 

• When using actual household expenses or an accountable plan, it is important to keep detailed records of all your expenses for at least three years. All receipts should be kept in case you are audited by the IRS, so you can back up your home office claims.

• Home office deductions are limited to the gross income earned by the business. Disallowed home office expenses are carried forward to the following year.

How you properly make your home office deductions depends on the type of entity you own.

Sole Proprietorship

For a sole proprietor, the home office deduction is taken on Schedule C using a pro-rata allocation of actual household expenses or via the simplified method. Both homeowners and renters can take it, and the office can be located in a single-family residence, condo, apartment or houseboat.

• Actual Household Expenses: Takes the pro-rata allocation of actual household expenses. You will need to provide your CPA with your actual, annual household expenses, the total square footage of your home office space and the square footage of your entire house. Depreciation (a tax calculation that quantifies the normal wear and tear of your office assets) will be taken on the office space area, but it must be recaptured when the home is sold. This means when you sell your home, the depreciation you have taken over the years, turns into gains taxed at 25%. 

• Simplified Method: Takes $5 per square foot of the dedicated office space up to 300 square feet. The deduction using simplified method is only available if the business has a net profit. Depreciation is not taken when using the simplified method, and it does not have a carryover provision.

S-Corporation

The simplified method is not available for s-corporation owners, however, you can deduct actual expenses using one of two methods: 

• An Accountable Plan: This plan allows you to regularly reimburse yourself for your home office expenses by taking the percentage of your dedicated home office space against your entire home and multiply each expense by that number. (i.e. a 150 square foot office space in a 2,000 square foot home = 7.5%. 7.5% of a $200 power bill = $15.00) You must submit an invoice to the business each month or each quarter for all pro rata expenses and receive reimbursement.  Since actual expenses are being reimbursed, your business’ taxable income is reduced, and you don’t have to report this on your Form 1040. The key to creating an accountable plan is keeping a detailed log of expenses, including all receipts. If records, expense logs and receipts are not maintained, then the payments made to a shareholder become taxable income that must be reported on your W-2. If you wish to set up an accountable plan, we recommend codifying it with an official agreement.

• Charge Rent: You can charge rent to the business for the use of home office space and record this rental income on Schedule E of your tax return. Your office space rental would be treated just like any other rental; you would take depreciation and offset your rental income with your expenses (allocated the same way as in the accountable plan). On your business tax return, you can take a deduction for office rent. In reality, the amount of rent doesn’t matter since it’s a wash. The income you claim on your Schedule E will be reflected in reduced income on your K-1. However, the amount of rent you charge DOES matter to the IRS because you need to treat it as an “arms-length transaction.” In other words, you can only charge the amount of rent you would charge to a business you didn’t own. If the IRS perceives favorable treatment, at best they may say it’s a gift, or at worst, they may say your s-corp isn’t truly an independent business, which could have expensive ramifications. You don’t want to charge an exorbitant amount of rent, because income tax will be due on any net profit earned from renting the space to your business. As explained above, since you aren’t really getting any additional income from the rent you don’t want to pay taxes on it.

Partnership

A partner has two options to take deductions for home office space:

• Unreimbursed Partner Expense: If your partnership agreement or written business policy states that a partner may be required to pay out of pocket for expenses without reimbursement, then home office expenses may be deducted on the partner’s individual tax return as an unreimbursed partner expense (UPE). The UPE has a couple of benefits: it reduces self-employment tax, and the deduction is allowed even if the partnership has a tax loss for the year.

• An Accountable Plan: This operates the same way as described under s-corporation. An accountable plan has a greater tax benefit than a UPE in two ways:

  • The reimbursement from the partnership is tax free.

  • Taxable net income on the K-1 is reduced since the partnership can take the expense.

One final bonus of having a home office as your principal place of business is that travel between home and work locations is considered a deductible business expense. So, when you are sitting in traffic wishing you were working from home, take heart that you can deduct the miles to and from the office from your taxes.

For many people, the home office deduction is a very helpful tax benefit. For others, the work that goes into recordkeeping isn’t worth it. Your personal situation will dictate if taking the home office deduction is worthwhile.

We are happy to help you analyze your home office deduction options and make a decision that positively impacts your personal and business tax situation. Reach out if you’d like to schedule a consultation.