Self-employment Deduction Benefits

One of the great benefits of being self-employed and working from home is the Home Office Deduction (video version here).  To qualify for the home office deduction, your home office needs to be used exclusively on a regular basis as your principal place of business. “regular use” isn’t defined in the Internal Revenue Code.  Some court cases indicate “regular use” to be about 3 or 4 days a week for 10-12.  If you’re working only one 5 hour day a week, your use may not be considered regular and the deduction may be disallowed.

To take the home office deduction, you use Form 8829 and report that deduction under business use of your home on Schedule C.  There are two different ways to take the home office deduction, the actual and simplified methods.  The Actual expense deduction looks at direct and indirect expenses of your home. It allows you to claim a percentage of your utility bills like sewer, water, electricity, gas, and mortgage or rent, based on the percentage of your home used for your home office.  If you’re wondering about internet, phone bill, or other expense deductions, check out the “Deductible Expenses” blog post here. 

Actual Expenses Home Office Deduction

For the actual expenses deduction, I’ll discuss three ways to figure out your home use percentage.  One is to measure the square footage of your office and divide it by the total square footage of your house.  The second method is the number of rooms method.  If all of the rooms in your house are roughly the same size, you can take your office, 1 room, and divide it by the total number of rooms.  Since most houses vary quite a bit in room size, this isn’t usually a feasible option for most people.  The final way I’ll discuss to calculate your home office use percentage is the net square footage method.  This is really just an expansion of the first method I mentioned.  You figure out the square footage of your office like in the first method, but instead of dividing it by the gross square footage of your home, you use the net square footage.

In the net square footage calculation, you subtract square footage from common areas (such as hallways, foyers, stairways, landings, entranceways) as well as outside walls, water heaters, and heating and cooling equipment.  To most taxpayers, this method isn’t as well known as the other two, but it’s definitely one of the most powerful.  It’s the method I prefer to use when filing taxes, if the pros outweigh the cons, which I’ll discuss in a minute.  The IRS has stated: “You can use any reasonable method to determine the business percentage”.  This net square footage method is commonly found in cost accounting practices and is used by government contractors and educational institutions. 

Actual expenses related directly to your home office, like painting, professional cleaning, or other general repairs, can be deducted 100%.  Indirect expenses like utilities and mortgage or rent you use your calculated office percent to claim a portion of it.  You can also claim depreciation of your house for your home office.

Depreciation Recapture

This is where one of the main downsides to using the actual expenses method comes in.  You will be subject to depreciation recapture of your home for the business use of your office.  Even if you don’t claim any depreciation of your home, you will be taxed on what you COULD HAVE depreciated.  This depreciation recapture is taxed at 25%.  For example, if you depreciated $4,000 worth of office space over several years, and then sold your home, $4,000 of that sale may be taxed at 25% to “recapture” the depreciation and you’ll owe a thousand dollars in taxes.

Simplified Method Home Office Deduction

The simplified method for deducting your home office gives you a flat rate of $5/sq foot, up to 300 square feet.  If you tell your accountant you have a home office, and they give you a flat-rate deduction without asking about the size of your office, that should be a BIG red flag, ESPECIALLY if they max out the flat rate deduction for $1,500 (check out more about vetting your tax preparer here). This method may not give you as big of a deduction, but it may be more worthwhile than trying to keep track of your home office depreciation over the years, adjusting the basis of your house, and paying the recapture tax of 25% of the portion of your house you could have depreciated.

Additionally, one good thing about the simplified method is that it doesn’t affect your home value at all.  All profit from the sale your home would be yours to keep, tax-free, as long as you qualify for the home sale exclusion, which can exclude up to 500k in profit.  Briefly, the three criteria for that are: owning your home for at least two years, used it as your primary residence for two of the previous 5 years, and you haven’t claimed a home sale exclusion in the last two years.

Putting it All Together

• The home office deduction is for a space that is only used regularly and exclusively for self-employment.
• Two ways to calculate the deduct: simplified and actual.
• Taking the “simplified” method is… well, simple.
• Actual method is almost definitely the way to go if renting, but it could also be beneficial if you own a home.
• You should take depreciation recapture into consideration if you’re using the actual method for a home you own.
• If you meet the criteria to take the deduction (or any deduction), take it!

One Last Comment on Deductions

“Audit” is considered a dirty word and people in online social groups throw it around a lot. It makes people hesitant to take deductions they are entitled to. If you have supporting documentation, there’s no reason to worry. I’ve been audited before and it’s nothing scary or intimidating to worry about. If you are ever audited and need help, reassurance, or explanation, just reach out by email at Chad@YourTaxPrep.com. You can also use the contact form on our website.