Many entrepreneurs start their business out of their own homes.
In fact, the Small Business Administration reports that around 50 percent of small businesses are home-based firms. With the rise of solopreneurs, consultants, marketing professionals, freelancers, and the ease of selling products via an online platform, it’s no wonder this new wave of home-based businesses is becoming popular.
But then comes tax time…
And now what?
Your business didn’t pay rent or utilities. Sure, you upgraded your internet for faster speeds since you often Skype clients, but that was charged to your personal credit card. And what about the fact that you had to find a three bedroom apartment to fit your fit your family and office instead of renting that cute two bedroom apartment that was more affordable?
Well, you’re in luck! All those additional expenses incurred when using part of your home as an office are tax deductible. So keep track, because when tax time rolls around you’ll want to make the most of these deductions.
Now, for the fun part… Correction: not so fun part. Let’s take deeper look into the rules…
Do I qualify for the home office deduction?
There are only two qualifications that must be met in order to claim the home office expense:
Rule #1: Your office space must be used regularly and exclusively for business.
The idea is that personal activities should be limited, similar to what is permitted in an office building. But what does this mean exactly? Well, it looks different for everyone.
The dining table that holds your laptop, family dinners, and the kids’ homework is not tax deductible because it’s not used exclusively for business. However, if your dining room table actually was your office desk and was off limits to food (hello spills on important documents!) or kids homework (no distractions while you’re on the phone, please) then it could qualify if used exclusively for business.
Want another example?
That corner of your master bedroom that was converted into an office space is a-okay but that corner of your master bedroom that is also your vanity and the kid’s favorite reading nook might not cut it.
Okay, one more…
The spare bedroom that you converted into your salon? Tax deductible. But the part of your garage that you move the cars out of to pop up a mirror and chair before a client comes over? Ehh, not so much. In this case, it’s main function is a garage, not a salon.
Your office needs to be used regularly AND exclusively for business.
Rule #2: Your office space should be the principal place of your business.
While you may meet a client at a cafe to discuss some upcoming marketing tactics, if your home office is you main hub, then don’t fret. This rule is not saying your office must be the only place where you conduct business. What is it saying is, if you rent out a store front and spend most of your day there, then your home office is not a deductible expense.
Note: there are a few exceptions to these rules, such as daycare services and storage facilities. Refer to the IRS website for more information.
How do I calculate expenses for my home office?
There are two ways you can calculate your home office expense:
The simplified method allows taxpayers to multiply a prescribed rate (set by the IRS) by the allowable square footage of the office space. It’s convenient to use and saves taxpayers time. The allowance may change from year to year, so be aware of current rates. For 2019, the set rate is $5 per square foot with a maximum space of 300 square feet. If your dedicated office space is more than 300 square feet use the method below.
Unlike the simplified method, deducting actual expenses takes into account how much you paid for rent, mortgage interest, utilities, insurance, repairs, and depreciation. Generally, these expenses are multiplied by the percentage of your home devoted to business. To calculate the business percentage, measure the square footage of your office space and divide it by the total area of your home.
What if my business had losses? Can I still take the home office expense?
The home office deduction has very clear rules about business losses and limitations. The deduction is limited to business net income which means it cannot create a loss. So if you do not have income, you cannot take the expense. At the same time, if you have net income in your business (revenue – expenses = net income), the home office deduction may still be limited if it is more than your net income.
For example, if your business earned $2,800 and had expenses totaling $2,000, your net income would be $800. Now, let’s say you qualify for a home office deduction of $1,000. Because the home office deduction cannot create a loss, you can only take $800 of the expense.
So, what happens to the other $200 of expenses you incurred?
If you used actual expenses to calculate your deduction, the $200 can be carried over and will benefit you in future years.
The disadvantage to using the simplified method (also known as the safe-harbor method) is that any non-deductible portion cannot be carried over and, in essence, are lost forever.
What other questions should I be asking?
I want to acknowledge that there are a lot of “ifs” and “buts” and unique scenarios to consider. If you are struggling to find an answer to your questions, I highly recommend you talk to a knowledgeable tax preparer (such as myself) and/or refer to the IRS website for more information.