If you are self employed and use part of your home for business, you may be able to deduct expenses for the business use of your home. These expenses include mortgage interest, insurance, utilities, repairs, and depreciation. The home office deduction is available for homeowners and renters, and applies to all types of homes. For most tax payers this seems like a no-brainer; the more deductions I can take the lower taxes I will pay. But in this case, the marginal benefit from tax savings may not make up for hidden tax liabilities down the road. This blog post will cover the pros and cons of the home office deduction and will discuss how you can avoid the home office trap.
To qualify for the self employed home office deduction you must pass the two factor test.
- You must regularly use part of your home exclusively for conducting business. For example, if you use an extra room to run your business, you can take a home office deduction for that extra room. However, if you use that room for personal use as well as business use then you do not qualify for the home office deduction.
- You must show that you use your home as your principal place of business. If you conduct business at a location outside of your home, but also use your home substantially and regularly to conduct business, you may qualify for a home office deduction. For example, if you have in-person meetings with patients, clients, or customers in your home in the normal course of your business, even though you also carry on business at another location, you can deduct your expenses for the part of your home used exclusively and regularly for business.
Taxpayers using the regular method (required for tax years 2012 and prior) must determine the actual expenses of their home office. Generally, when using the regular method, deductions for a home office are based on the percentage of your home devoted to business use. So, if you use a whole room or part of a room for conducting your business, you need to figure out the percentage of your home devoted to your business activities. For example, if the total square footage of your home is 1,500 square feet and your home office is 150 square feet then you are able to deduct 10% (150/1500) of your mortgage interest, insurance and utilities on your schedule C. Additionally, if you itemize your deductions then you will take the remained, 90% in the case of the above example, as a deduction on schedule A of your 1040.
The main benefit for taking the home office deduction is the potential tax savings. Expenses which are not usually deductible, such as utilities, may be partially deductible against ordinary income. Even more so, expenses that are usually deducted as itemized deductions can be partially taken as home office expenses. This may be beneficial if your itemized deductions are limited because your adjusted gross income exceeds certain thresholds. Shifting a portion of these itemized deductions to fully deductible home office expenses can save tax dollars in certain circumstances. Lastly, you can depreciate the portion of your home office for tax purposes which may have substantial tax benefits.
For starters, the home office deduction does have its limitations. Firstly, a taxpayer can not take a loss on a schedule C using the home office deduction. For example, if your tentative profit before factoring in the home office deduction is $500 and your home office deduction is $5,000 then you are limited to $500. The remaining $4,500 will be carried forward and used against future profits in subsequent tax years. If you have a loss on a schedule C then you will not be able to deduct any portion of the home office deduction in the current year.
The Home Office Deduction Trap (Warning: this gets complicated)
The true tax consequence of taking the home office deduction comes when you sell your primary residence. Generally, most taxpayers are able to exclude up to $250,000 ($500,000 if filing married joint) of capital gains from the sale of their primary residence. However, if you took the home office deduction then you can only exclude the gain attributable to the portion of the residence that was not used for business purposes. A separate calculation must be made to determine the taxable gain for the portion of the home that was used as a home office. This means that if you have a $100,000 gain from the sale of your home, of which 10% was used as a home office, then $90,000 would be excluded under the $250,000 exclusion but $10,000 would be considered a taxable gain. However, this basic calculation does not account for depreciation.
To correctly allocate the gain or loss from the sale of your primary residence with a home office you must compute the gain or loss separately. If your personal space and home office consist of 90% and 10%, respectively, of your total home, then you must allocate the original cost basis accordingly. For example, if you purchased your home for $100,000, $90,000 would be allocated to the original cost basis of the home and $10,000 would be allocated to the original cost basis of the home office. The basis for each may increase due to any substantial improvements or decrease from depreciation. For example, if you spend $5,000 upgrading your home office then the new basis of the home office would be $15,000. Now lets assume you took $10,000 worth of depreciation on your Sch. C as a home office deduction; your new basis in the home office would be $5,000 ($10,000 original cost basis + $5,000 improvements – $10,000 depreciation).
If you were to sell the home for $200,000 then $20,000 of the proceeds would be attributable to the home office. This means you would recognize a $15,000 gain ($20,000 proceeds – $5,000 basis). Even worse, $10,000 of this gain is recaptured as a section 1250 gain. This means that $10,000 would not be taxed at the usual capital gains rate of 10% or 15% but at a rate as high as 25%.
Now, I know what you’re thinking, “but what if I don’t take depreciation for my home office?” It doesn’t matter! The IRS rules dictate that you must subtract any depreciation you took, or didn’t take but could have taken, when calculating your adjusted cost basis. This means you will pay tax on deductions you never took in the first place. This is where it gets crazy; you have to compute the amount of depreciation you could have taken on your home office regardless if you took depreciation or not…. since inception. If you have taken the home office deductions for several years this would seem like an impossible task.
Now you’re probably thinking, “OK, well the day before I sell my home I will turn my home office into a man cave and presto… no more home office.” Nice try but that won’t work. If you can’t say yes to all three of these conditions then your home office is still considered a home office at the date of sale.
- You weren’t using the space for business at the time you sold the property
- You didn’t earn any business income from the space in the year you sold your home
- You used the space as residence space for 2 years out of the 5 years leading up to the sale
This means you will have to wait 2 years before you can sell your home after turning your home office into personal space.
How to Avoid the Home Office Trap
There are two ways you can avoid the home office trap. The first one is really simple; don’t use the home office deduction. If you still want to take the deduction then the second option is to use the simplified method. The simplified method allows you to deduct $5 per square foot of your home office, up to 300 square feet. You don’t have to worry about splitting expenses between the home office deduction and your itemized deduction, you can carryover any unused deductions and you won’t be subject to recapture rules. However, if you switch from the regular method to the simplified method then you will lose any unused carry forward expenses that were disallowed in prior years.
Although taking the home office deduction can have its pros and cons it’s up to the taxpayer and their CPA to determine what option is best for them. If you do chose to go ahead and use the regular method in computing the home office deduction you should make sure to take advantage of depreciation. Since the IRS reduces the basis of the home office by allowable depreciation, whether or not it was deducted, you might as well get the benefit of taking depreciation in the years prior to the sale of your home. If you have questions on your specific tax situation don’t be afraid to contact your CPA.
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