Business Home Office Deduction: Qualifying and Calculating

home office tax deduction Dec 27, 2019

As a business owner you may wonder if you qualify for the IRS home office tax deduction. This post will explain what it is and how it is calculated based on IRS Publication 587: Business Use of Your Home.

It is helpful to be educated on the rules for yourself. This is important because having some knowledge will help discuss this option with your tax preparer. However, if you intend to take this deduction on your federal taxes, please use your trained tax professional to ensure the calculation is accurate. It is not recommended to take this deduction without professional consultation.

There are special rules if you use part of your home for storage, rental use and as a daycare facility. Those rules are not discussed here.

Form of business

The home office deduction is now reserved for business owners. Until the provisions of the Tax Cuts and Jobs Act (TCJA) expire in 2025, employees cannot deduct miscellaneous unreimbursed employment expenses.

Self-Employed Owners
If you are self-employed as a sole proprietor or LLC owner, and you have confirmed you qualify, you will take the home office deduction on Schedule C, line 30, of your IRS Form 1040, along with your other business expenses.

Partnerships
For a member of a partnership to take this deduction in must be required under the partnership agreement. Partnership agreements are legal documents so speak with both your attorney and your tax preparer.

Owners of entities taxed as an S-Corp
There are additional steps for an entity taxed as an S-Corporation to take a deduction for the home office of an employee or owner. You will need to set up an accountable plan first and require the home office for the convenience of your S-Corp business as well as meeting the other requirements for the home office deduction. This will enable you to reimburse yourself or an employee for home office expenses. You or the employee will supply all relevant documentation for expenses and square footage, and the business retains this documentation. 

Under an accountable plan, reimbursements are not taxable to the employee. The accountable plan will set forth the rules the employee for reimbursement. If you do not establish an accountable plan, reimbursed expenses are taxed as wages on the employees form W2, including the owners W2. 

Qualifying

To be able to deduct expenses related to a home office you need to meet several criteria. First, you must use part of your home or separate structure on your property regularly and exclusively for business as either:

  1. a principal place of business, or
  2. a place to meet patients, clients or customers, or
  3. a separate free-standing structure used for business

One of these three situations must exist to take the home office deduction. If you do not have a free-standing structure and you do not use your home office for meeting with patients, clients or customers either in person, video or by phone, then your home office must be a principal place of business. In all cases, to be deductible the home office must be regularly and exclusively used for business.

Regular and exclusive business use

The IRS has visited tax payer homes to investigate whether the regular and exclusive business use tests are met. So if you do not meet these tests, do not take the home office deduction. The IRS provides a diagram to help determine if you meet these tests, see IRS Pub 587, Figure A.

Regular use
The home office space must be used regularly, not occasionally, for business. The IRS does not have a specific a definition of "regularly" so it is important to look at the facts and circumstances of your business situation.

For example, if you conduct administrative task daily but only do them in your home office once or twice a month, that would not meet the regular use standard. However, if you conduct administrative tasks almost every weekday and they are always done in your home office, the administrative tasks are being done regularly in your home office. 

Exclusive use
Exclusively using part of your home for your trade or business means exactly that: using it for nothing else ever. The deductible space does not need to be a whole room, it can be part of a room. However, the space cannot be used for hobbies, guests or your family.

Let's say you have a spare room for guests but part of the room is exclusively your office space. When guests stay in the room they do not use the office area. The portion of the room used exclusively for business qualifies for this deduction. The portion of the room used sometimes for guests, even once per year, will not qualify. 

The exclusivity tests applies to all business home office space except those used as a daycare facility or for storage.

Business use
To be a business deduction the regular tasks need to have a business purpose. This means you have a business and report business income and expenses. If your activities constitute a hobby, you will not qualify for a home office deduction. The IRS provides nine factors to consider when determining if your activities constitute a hobby or a business. See IRS Tax Tips: Hobby or Business.

Meeting with patients, clients or customers

You can qualify to take the home office deduction if you use your home office regularly as a place to physically meet with patients, clients or customers. You can qualify even if you regularly meet with patients, clients or customers in other locations too. The home office does not have to be your principal place of business if you meet this requirement. However, you must meet one additional test: using your home for this purpose must be integral to the conduct of your business. For fun, the IRS does not define integral. It is up to you and your tax preparer to decide.

If you only meet with patients, clients or customers occasionally in your home, or occasionally use your home for business phone calls, this is not likely to meet the requirement of it being integral to the conduct of your business. A good question to ask yourself is whether your home office is needed for this activity. If you can and do take client phone calls anywhere you happen to be, then taking them at home does not sound integral. However, if you have a set time and dedicated space for in person appointments, and you use your home office regularly and exclusively for this purpose, that would appear to be an integral part of your business activities.

The IRS specifies meeting with patients, clients or customers on your premises. If you meet with clients electronically such with video conferencing, then you need to meet the principle place of business test below.

Separate structure

If you use a separate free-standing structure regularly and exclusively for your business, it does not have to be a principal place of business and you do not have to use it to meet with patients, clients or customers to qualify for the deduction. This could be a garage, barn, shed or similar type of building on the same property as your home. 

Principle place of business

You are permitted to have more than one business location and one of the locations can be a home office. However, unless your office is used regularly and exclusively for meeting with patients, clients or customers or is a separate free-standing structure, the space must constitute a principle place of business. To determine if your home office counts as a principle place of business consider:

  • The importance of the activities conducted at the home office versus your other business locations.

  • The amount of time you spend at each of your business locations including the home office.

Home office used for administration and management activities
If you use your home office for administration and management activities it may qualify as a principle place of business on that basis. IRS Publication 587 makes the following statement regarding qualifying for a principal place of business:

Your home office will qualify as your principal place of business if you meet the following requirements.

  • You use it exclusively and regularly for administration or management activities of your trade or business.

  • You have no other fixed location where you conduct substantial administrative or management activities of your trade or business.

Administrative and management activities include billing, bookkeeping, ordering supplies, scheduling and writing reports. The IRS says the following activities will NOT disqualify your home office as a principal place of business:

  1. Outsourcing or delegating some administrative and management activities to others,

  2. Conducting administrative and management activities at temporary places like a car or hotel room,

  3. Occasionally conducting administrative and management activities at another business location you own, rent or use,

  4. Engaging in nonadministrative and nonmanagement activities outside your home, such as meeting with clients or customers at a separate office outside of your home and

  5. Having another location, such as a rented office, where you could conduct administrative and management activities but you choose to conduct them in your home office. 

Controversy and court case
There is confusion on taking a home office deduction when you use the home office for administrative and management activities, where most of your revenue generating activities occur at a separate fixed location. In a well known course case, Commissioner v. Soliman, the IRS fought all the way to the U.S. Supreme Court to deny a deduction for an anesthesiologist who used a home office for administrative tasks, and the IRS won.

However, the current version of the IRS Publication 587 reverses this stance. The IRS uses the same facts of the above case as an example of when the home office IS actually allowed. See this link, example #3. The example concludes: 

Paul's home office qualifies as his principal place of business for deducting expenses for its use. He conducts administrative or management activities for his business as an anesthesiologist there and he has no other fixed location where he conducts substantial administrative or management activities for this business. His choice to use his home office instead of the one provided by the hospital does not disqualify his home office from being his principal place of business. His performance of substantial nonadministrative or nonmanagement activities at fixed locations outside his home also does not disqualify his home office from being his principal place of business. 

Therefore, a home office used regularly and exclusively for administration and management activities is currently allowed. If your tax preparer is familiar with the tax case but not the subsequent change in stance by the IRS, have a discussion with them to see if your home office would be allowed under the revised IRS guidance.

To take the home office deduction for administrative and management tasks, avoid regularly doing those specific administrative and management activities at another office location. If you have another office location outside of your home where you regularly conduct those administrative and management activities, the home office will not qualify as a principle place of business for these activities. 

More than one trade or business

You can have more than one trade or business in your home. If you have two businesses, you need to apply the home office deduction requirements separately to each business as well as perform additional calculations. You need to use the same method for each calculation (see IRS FAQ Question #9). 

Calculating the deduction

Once you have determined that you qualify to take the deduction, now you can calculate how much that deduction will be. Your experienced tax preparer can help you evaluate which method of calculating the deduction is best for the current year. You have two options for calculating the deduction:

  1. Simplified method
  2. Actual expenses

Simplified method

Each year you can choose to take or not take the simplified method. If you choose this method you do not have to allocate actual expenses between personal and business and you do not have to substantiate the expenses. 

Allowable square feet x $5
Under the simplified method you are limited to a maximum of 300 square feet per home. If your actual home office square footage is less than 300 square feet, then you use the smaller actual square feet. If you have multiple businesses operating in your home, such as a spouse or roommate with a home office, or you have multiple businesses, the limit is 300 total square feet for all businesses. The deduction is calculated by taking the allow able square footage (300 or less) times $5. 

Partial year home office
If you did not use your home office all year, you also need to know how many days you used it. You only take the deduction for the days you had a home office, and only for a given month if you used it for 15 or more days that month (see IRS FAQ Question #13). 

Worksheet
The IRS provides a worksheet to calculate the home office deduction under the simplified method. However, it is still wise to use a tax preparer.

Actual expenses

Using actual expenses requires determining the actual square footage used regularly and exclusively for your home office and and actual expenses that relate to the home office. Home expenses are categorized as one of three types: direct, indirect or unrelated to your business. 

Direct expenses
Direct expenses relate only to the home office space, not other parts of the home, and are fully deductible under the actual expenses method. The IRS uses an example of painting the walls of the home office as a fully deductible, direct expense. 

Indirect expenses
Costs related to the general operation of your home are considered indirect expenses for your business home office. These are deductible based on the percentage of your home used for business. Payments for utilities is an example of an indirect expense.

Unrelated expenses
If an expense of your home is completely unrelated to your business the expense is not deductible at all. The IRS uses lawn care and painting a room not used for business as an unrelated expense. 

Rules for actual expenses
There are many rules for deducting the actual expenses of your home for the home office deduction. For example, the main phone line in your home is a non-deductible personal expense. A second phone line used for business would be deductible. A portion of a security system that protects all the doors and windows of your home, can be included as in indirect expense.

Like the simplified method, when using actual expenses you can only deduct expenses during the portion of the year that you actually used your home office for business. 

If you are considering taking the home office deduction using the actual expenses method or you want to find out which will be better, make a list of all your household expenses and gather up the most recent bill for each one. Your tax preparer can go through the list and help discern which ones are direct, indirect and unrelated to your home office and perform the calculation for you. Then you can decide if the simplified method or actual expenses results in a larger deduction.

Alternating methods and deduction limits

You can take the simplified method in one year and choose the actual expenses method in the next year. You can use whichever method results in a preferable tax treatment.

You cannot use the home office deduction if you have a business loss and the deduction cannot be used to create a business loss. So if your home office deduction was going to be $1,500 but your business only made $800, you can only deduct $800.

If you use the simplified method and cannot take the whole deduction this year because you didn't have enough income, you cannot carry it forward to next year. You lose the remaining deduction you could not take.

If you use the actual expenses method and you can't take the whole deduction this year, you can carry that amount forward to the following year but to be able to actually take the remaining unused deduction you have to again choose the actual expenses method.  

Depreciation of your home

If you use the actual expense method you can also take depreciation expense on the portion of your home used for business. However, when you sell your home later for a gain, you have to recapture the depreciation amount. You cannot take depreciation if you use the simplified method. A tax preparer can help evaluate the option to take depreciation.

If you move

If you move during the year you can only used the simplified method for one of your home offices during the year, not both. See IRS Home Office FAQ Question #6

Other business expenses

Whether or not you qualify for the home office deduction, you can still take deductions for business expenses unrelated to the use of your home. These include supplies, computers and equipment, etc. Whether you use these business items at home or at your office, they are allowed business expenses.

Bottom line

Taking the home office deduction is not simple. Make sure you understand the general rules, gather up your expenses and then sit down with your tax preparer to discuss whether you qualify for this deduction and the best method to use when taking the deduction. 

Questions: email [email protected]

Jennie Schottmiller, LMFT, CPA is a licensed marriage and family therapist who practiced as a CPA prior to becoming a therapist. She has an active solo therapy practice and runs a facebook group for clinicians and offers courses to help small business owners with accounting, tax and financial analysis matters.

Disclaimer: This blog is for education only. Please consult with a qualified professional when you have any questions about your personal accounting, tax or legal situation. Information contained in this post is for informational purposes only and not intended to replace professional advice.

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