One of the best tax breaks out there is the home office (or home studio) deduction. In tax terms, this essentially turns a portion of your nondeductible personal expenses (your home) into deductible business expenses (a workplace). A lot of people are confused about the rules, and some people are scared to take the deduction at all because they’ve heard that it can be a red flag to the IRS. As long as you are following the rules correctly, there is nothing wrong with taking the deduction. And it’s a big one! So here is some help.
First, when can you claim a home office/home studio?
You have to use it both exclusively and regularly.
Exclusive use means that the space is a dedicated workspace – no kids watching TV in there after hours, no guests staying there. There is no wiggle room on this part. That said, you are allowed to section off portion of a room as your office, so long as the demarcation is clear (a curtain, a wall of bookshelves). If you do this, your deductible office space is only the demarcated portion. To document your home studio/office, I recommend taking pictures of it. These are especially useful if you move, and need to prove the legitimacy of the deduction after you can no longer access it.
Regular means just that – but it doesn’t necessarily mean daily. If you work in your home studio one day a week, that counts as regular use.
If you’re a freelancer, the chances are good that you need the home office – to do your work, to meet with clients, or for administrative tasks. But what if you’re an employee? Employees can still take the home office deduction if they work there at the convenience of their employer. I’ll use my husband as an example. Last year, my husband, a computer programmer, was working remotely for a company based in New York. They have offices in Union Square, and would love (and even prefer) him to work there. Since my husband preferred to stay in our sweet little city in the mountains, he did not get to claim a home office, despite the fact that that’s where he does all his work. In other words, he chose to work from home for his convenience, not his company’s. However, this year, he changed jobs to a company that hires a 100% remote workforce. Because there is no office provided to him by his employer, the home office he has been using all along is now deductible for him.
So what exactly can I deduct?
You can claim both direct and indirect expenses of your home office. Direct expenses are the ones that relate exclusively to that space – painting the office, installing bookshelves in the office. Indirect expenses are pro-rated expenses of running your entire home. So if your office is 15% of the square footage of your entire home, then you can deduct 15% of the costs of your home – the mortgage (or rent), property insurance, and utilities. In addition, if you own your home, you deduct depreciation on the home office portion of your home. While you do have to account for this accumulated depreciation when you eventually sell your home,* this depreciation on your home office essentially gives you a big tax savings each year. And a word to the wise – while many more taxpayers are taking home office deductions as we move deeper into a freelance economy, be realistic. If you claim 80% of your total home as a home office, the IRS is likely to ask you to prove it, in the form of a friendly audit letter. This is partly because your home expenses are normally considered personal, ie, nondeductible. So, a high percentage of your home claimed as an office looks fishy – like you’re trying to claim personal expenses. Remember, it must be “exclusively used” as an office – so although there is no explicit limit, at 80% of your total living space, the IRS is reasonably going to question where you sleep, eat and shower, not to mention relax and host friends.
As of 2013, there is a new simplified home-office rule that allows you to deduct a flat $5 per square foot, up to a maximum of 300 square feet (ie, up to $1,500). Using this method, there is no depreciation to account for (neither in the current tax year, or when you sell your home), and you do not need to keep records (for utilities, insurance, etc) as you do with the regular method. You are allowed to switch back and forth in different tax years based on which method is more advantageous to you.
And finally, an important note on all home office deductions: you are only allowed to claim a home office deduction up to the amount of your income from that business activity. So long as you’re making a profit, this is no big deal. But if your business is running a loss this year, you do not get to take this deduction at all.
*It’s a pretty complex subject, but if you want to look it up, it’s called “capital gains tax on the unrecaptured section 1250 gain for home office”
DISCLAIMER: True tax advice is a two-way conversation, and your accountant needs to hear your full situation to apply the rules correctly in your case. This post is meant for general information only. Please don’t act on this alone.