By Jean Kruse / Guest Editorial
When historians compile the list of the greatest innovations to benefit small business, the home office will surely rank near the top.
The ability to serve customers and earn a living from the convenience of home has helped thousands of entrepreneurs minimize operating costs, keep personal and professional responsibilities in balance, and heighten productivity by eliminating commutes, restricted work hours and interruptions.
What’s more, the IRS allows non-corporate small business owners to deduct expenses related to their home office on their tax return. But while the home office deduction is popular, it’s also frequently misunderstood and sometimes abused. Though claiming a home office doesn’t automatically put one on the IRS’s audit list, small business owners should nevertheless be honest and accurate about the deduction.
The home office deduction is based on two fundamental requirements:
1. Regular and exclusive use means that the space in your home is used only for conducting business. It can serve no other purpose, even if it’s occasional (e.g., dining room, kids’ playroom, spare bedroom for guests, etc.) Note, however, that the deduction isn’t limited to a full room. If you set aside half of a spare bedroom for a home office, you can deduct half of that room’s floor space. Again, make sure nothing unrelated to your business takes place in that area.
2. You must also show that your home office is your principal place of business. That said, there are a few exceptions to this requirement. If your business is based elsewhere, but you regularly conduct meetings with clients or customers at home, that meeting space may qualify for the deduction, again as long as that’s all it’s used for. Also, if you store inventory that is for sale by your business, you can take a deduction for that related space.
If your business is a daycare, there are special rules because you may use parts of most of your home. I recommend you read the IRS Publication 587, “Business Use of Your Home,” which you will find at www.irs.gov.
Regardless of how large or small your home office is, make sure you accurately measure the floor space and divide it by your home’s total square footage to determine the deductible percentage for the expenses mentioned below. Most accounting and business tax preparation software programs have built-in features to make these calculations.
Accurate recordkeeping is also important because the home office deduction may come into play when you sell your home. The probability that some of the profit on the sale of your home will become taxable may be a good reason to forego using the home office deduction.
As of 2013 there are now two methods for deducting home office expenses. The regular method, required prior to 2013, allows you to take as a deduction the percentage of exclusive use times certain expenses: home mortgage interest, property taxes and depreciation (if you own your home) or rent (if you don’t own), plus home insurance, utilities and repairs.
For example, if the total square footage of your home is 3,000 and the square feet of your home office is 300, then you would deduct 10 percent of those expenses. If you itemize your deductions, your home mortgage interest and property taxes are deductible on Schedule A. If you choose the regular method, you must prorate these two expenses and deduct some of them on Schedule C and the remainder on Schedule A.
The simplified optional method, which was introduced in 2013, requires that you comply with all of the exclusive use and principal place of business tests, but it allows you to simply deduct $5 times the computed square feet that you use for your business, up to a maximum of 300 square feet or a maximum deduction of $1,500. If you use this new method, you can deduct the entire amount of your home interest and property taxes on Schedule A – no allocation of these expenses is required.
In addition, since you are not deducting depreciation expenses if you use this method, when you sell your home there is no requirement to pay income tax on any part of the profit. Note that this method does not allow a deduction for any of the expenses listed in the regular method; the $5 per business-use square foot is the simplified and only deduction.
Keep in mind that any expense that is for only the home office space, not the entire home, can be deducted in full. Those expenses should be shown on Schedule C but not as an “office in home” expense.
Taxes are but one issue that small business owners often need help understanding. A great source of business advice is SCORE. Go to our website, www.scorecr.org, and sign up to receive free face-to-face or online mentoring.
Jean Kruse is a SCORE counselor and SCORE Iowa district president. She operated her own CPA firm for 13 years and in 1988, joined RSM McGladrey, a national firm, where she provided accounting and tax services to small businesses.