Home Offices, Tax Laws, and Other Important Considerations
Having a home office can be a dream come true. The ability to work in a setting of your own design and control, never getting stuck in traffic during a long commute, and opportunities to deduct some expenses from your income taxes are all very good reasons to consider working from home, if you are able. Now, many employers are increasingly supportive of the idea – it saves them overhead costs, improves employee satisfaction, and reduces turnover, unscheduled absences, and even increases productivity. Working from home also allows an employer to hire the best employees from anywhere in the world and conversely, for employees, gives the ability to work for a wider range of businesses and industries.
If you’re considering working from home for the first time, there are some important considerations to take into account. Strong time management skills and the ability to separate yourself from distractions at home are critical skills to making this arrangement work. But with a sound strategy for managing and separating home and office work, the advantages are significant.
Test for Regular and Exclusive Use
The first step to qualifying for home office deductions is to establish and regularly use a section of your home solely for your business activities. This is easily done if you have a separate room for your desk, files and supplies, but it might also be accomplished with a simple room partition and clear demarcation of the spaces. The two elements that the IRS will be looking for though are “regular and exclusive use” of the space. The exclusive use requirement is clearly defined, and an IRS auditor can be very serious about sticking to the letter of the law. You might use your home office space 60 hours a week for your legitimate office work, but if you allow a friend to sleep in the room overnight or allow family to use the room for homework or projects, it may be determined that you haven’t met this “exclusive use” requirement and will lose your home-office deductions. Regular use is less clearly defined, but generally an auditor will be looking for you to use the space for your work at least a few hours a day and not just once in a blue moon.
A Principal Place of Business
The next hurdle to overcome in qualifying for deductions is to establish your home office as a “principal place of business.” To meet this criterion, according to the IRS you must “a) use it exclusively and regularly for administrative or management activities of your trade or business,” and “b) have no other fixed location where you conduct substantial administrative or management activities of your trade or business.” Administrative and management activities can include such things as billing customers, taking business calls, conducting accounting for your business, writing reports, and ordering supplies. If you use your home office simply to manage your own investments (e.g. stocks and retirement), that doesn’t qualify since activities as an investor aren’t considered a business. However, if you work in a regular office three days a week and at home two days a week, you may still qualify as long as at least 50% of your administrative and management activities are conducted at home.
There are some exceptions and nuances to these rules. For example, if you use part of your home for caring for the elderly, disabled, or children during the day, you can use those parts of your home for private activities at night. Likewise, rules relating to the storage of supplies and product may also be more lenient when the volumes of inventories change over time. If there are any questions or concerns, please consult a tax expert.
Percentage of Home to Office Space and Square Foot Calculations
Once you’ve established your eligibility, it’s time to calculate exactly what types of expenses you can deduct from your business income in order to lower your tax base. Expenses relating directly to the business are usually the easiest to identify, and these include office supplies (again, no lending to the kids for their homework!), furniture, long distance phone calls made for your business, product for sale, file cabinets, and the like. Another sizable source of deductions, though, comes from the percentage of your house and its expenses that are utilized for the business. The most accurate way to find this is to measure or research the total livable square footage of your home (this excludes garages, decks, and the like,) then measure the specific space dedicated to your business. Divide the later by the former, and you’ll get a percentage. Again, special rules may come into play for elder-or child-care in the home if the space is for both work and private use. In that case, calculate the number of hours a year that the space is used to provide care and divide that into 8,760, which is the total number of hours in a year. You’ll then apply that percentage to the percentage of space for your net business use. For example, if you provide 2,500 hours a year in elder-care, but then use those same spaces for private use the rest of the time, that’s 28.5% of time used for your business. If the space you’re using for that business impacts 60% of your home (its safe to assume they wouldn’t have access to your bedroom, your bathroom, and other spaces), then 28.5% of 60% is 17.1%.
Once you have your eligible percentage of use calculated, you can simply apply that percentage to all allowable home costs. These include utilities, mortgage interest or rent, property taxes, homeowners insurance, HOA fees, and home maintenance expenses. When all is said and done, remember that your deductions can’t exceed your income from that business… you won’t be able to claim a tax loss by this approach.
IRS Red Flag?
There’s a conception that taking home office deductions may make you more liable to be selected for an audit, but there is little evidence of that and since 2013, the IRS has been loosening restrictions on deductions relating to home offices. The best way to avoid a negative audit continues to be what its always been: if you have a valid deduction and good records, claim it! If your “business” is really just a hobby, the space you use is really a guest room whose business use is occasional, and expenses are questionable, you’re likely better off not claiming those costs.
If you’re looking on how to transition to working from home, look now further! We have you covered with five ways to create the perfect home office.