Part 3 of 3: Easy Targets - Meals, Mileage, and Home Office deductions, soft audit targets for the self-employed.
“Soft target” is a military expression, referring to something that is relatively unprotected or vulnerable to an attack. An audit on your tax returns by the IRS is clearly not a military attack, but it can be quite brutal if your business expenses are… “open to interpretation”, or not well supported. This is the 3rd of 3 articles we have posted to help business owners understand how to best take advantage of some key deductions on your tax returns and the rules and requirements that will allow you to take those deductions with confidence that they are accurate and valid. You can find the first two articles here.
Many small business owners work out of their homes, and one of the most overlooked deductions available to them is the Home Office deduction. Here’s how it works.
First – who can take the deduction? This one, just like the meals and mileage expenses, is only available to the self-employed. If you work from home for your employer (very common since the pandemic) and receive a W2 as an employee, you are not eligible for the home office deduction. Suggestion: have a conversation with your employer if you are not receiving any reimbursements or consideration for expenses you pay out of pocket – increased utilities, supplies,…etc.
If you are self-employed, the requirements for eligibility are:
-Principal Place of Business – you may have more than one place of business, but to take the home office deduction, your home must be your main work location. That’s a little vague, but the importance of the activities you conduct and the amount of time you spend there are the main factors that determine if it’s your principal place of business.
-Exclusive Use – you must use the space only for business purposes. The dining room or kids playroom won’t qualify if you are using them for other purposes. The only exception to this is if you store inventory or product samples in your home and that is your only business location.
-Regular Use – the use must be consistent, not occasional or temporary.
What costs can you deduct? You can deduct your direct expenses – like supplies and equipment that are used only for business purposes, and also indirect expenses. Indirect expenses are the costs associated with your home that are not specifically for your business, things like your mortgage interest or rent, your utilities, real estate taxes, homeowner’s insurance,…etc. The direct expenses are 100% deductible, while the indirect expenses are calculated as a ratio of your home office space to your whole home. For example, if your home is 2000 square feet, and your home office space is 200 square feet, then 10% (200/2000) of your indirect expenses are deductible.
Depreciation? While I don’t recommend it, many people can include a depreciation expense on their home as part of their indirect expenses. This part of the deduction is calculated based on the value of your home when you began using it, and the same ratio explained above is applied to this basis. Why I’m not crazy about it: This expense can come back to bite you when you sell your home. You normally won’t have to pay taxes on the gains from selling your personal residence, but if you’ve depreciated your home for the home office deduction, that amount of gain will probably be taxable. Just not enough actual benefit, in my opinion, compared to the later tax risk. As always – please discuss this with your tax preparer and determine if you are eligible to take the depreciation deduction, and then you can decide if it is worth it to you.
Safe Harbor and a few more points to remember:
1. Safe Harbor – there’s a simplified way to take the deduction if you qualify but don’t want to document and calculate the expenses. It’s simply $5 per square foot of eligible office space up to 300 square feet – so a maximum of $1,500 deduction. Quick and easy.
2. You can still deduct on your itemized expenses (Schedule A) any qualifying amounts that are not included in your home office deduction for things like mortgage interest or real estate taxes, anything that you would normally list on your Schedule A.
3. Renters are eligible – your rent is an indirect expense, whether it’s a home, apartment, or even a boat.
4. Unattached outbuildings, shops and garages, …etc, also apply if they meet the other eligibility requirements.
The Home Office deduction can be a nice tax cut for the self-employed, so if you think you qualify for it, take the time and effort to discuss the details with your tax preparer. If you are looking for a tax accountant to help with your small business, you can contact us here.