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Home Office Tax Deductions for Small Business Owners

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Not so long ago, claiming a home office deduction was akin to pleading with the IRS to audit your tax return. Today, with more than one-third of the country working from home, the deduction is much less likely to trigger an audit and much easier to take.

When you work out of your residence in a home office — or if you otherwise use part of your home in your business — you can deduct expenses related to the business use of your home. As long as you use the space regularly and exclusively for business-related activity, IRS rules let you write off associated rent, utilities, real estate taxes, repairs, maintenance and other related expenses.

You can determine the value of your deduction in a couple of ways: the easy way and the hard way.

The regular, more difficult method values your home office by measuring actual expenditures against your overall residence expenses. However, because the regular method of calculation requires a lot of record keeping that may be burdensome for some small-business owners and entrepreneurs, the IRS introduced a simplified option beginning in the 2013 tax year.

With the simplified, easier option, the square footage of your space is multiplied by a prescribed rate. For 2015, the rate is $5 per square foot for up to 300 square feet of space. Your online tax software will walk you through steps for using the simplified option for your home office.

You can claim the home office deduction using form 1040 and 1040A, but not with 1040EZ. (See “1040EZ, 1040A or 1040: Deciding Which Tax Form to Use.”)

How to determine eligibility

When you meet the requirements, you can claim the deduction whether you’re a homeowner or a renter. Other than a hotel or other temporary lodging, you can use the deduction for any type of home where you reside: a single family home, an apartment, a condo or a houseboat.

The home office deduction rules also apply to free-standing structures. You can use a studio, garage or barn space as your home office as long as the structure meets the “exclusive and regular use” requirements.

However, there are quite a few conditions you’ll need to meet. Although your home office doesn’t have to be the only place you meet your clients or customers, it must be your principal place of business. And the space you’re using for business must be used exclusively for conducting business, so using a guest bedroom as both your office and a playroom for your children makes you ineligible.

“An extra bedroom works, as long as you don’t use it for guests, even a few days a year,” says Johanna Fox Turner, an accountant and certified financial planner in Mayfield, Kentucky. “You can also use a portion of a room as long as it is clearly delineated, such as a den divided between personal use and home office, divided by a bookcase.”

There are two exceptions to the exclusivity rule, however. If you provide day care services for children, the elderly (age 65 or older) or handicapped individuals in that part of the house, you can still claim business deductions, as long as you have a license, certification or approval as a day care center under state law, according to the IRS. The other exception to the exclusive use test is if you use the office for storage of inventory or product samples you sell in your business.

If eligible, you can deduct home business expenses using a Form 8829, and the amount is then reported on a Form 1040.

The actual vs. simplified method

After you’ve determined that your small business is eligible, you can either deduct actual expenses (get ready to do some math), or use the simplified deduction. Which method you should choose depends mainly on which nets you the bigger tax deduction.

If you deduct actual expenses, you can deduct direct expenses — such as painting or repairs solely in the home office — in full. Indirect expenses — mortgage interest, insurance, home utilities, real estate taxes, general home repairs — are deductible based on the percentage of your home used for business.

For example, let’s say you paid a total of $3,000 in mortgage interest, $1,000 in insurance premiums and $3,000 in utilities (all indirect expenses) plus $500 on a home office paint job (direct expense) in the 2015 tax year. Your home office takes up 300 square feet in a 2,000-square-foot home, so you’re eligible to deduct indirect expenses on 15% of your home.

You’d be eligible to claim a deduction of $1,050 in indirect expenses ($7,000 in expenses, multiplied by the 15% of space used in the home), plus $500 for the direct expense of painting the home office, for a total deduction of $1,550.

If you opt to take the simplified deduction, the IRS gives you a deduction of $5 per square foot of your home that is used for business, up to a maximum of 300 square feet, or $1,500. If your home office is over 300 square feet, you are not eligible to take the simplified method.

In this case, using the simplified method could make more sense since you’d only get $50 more in deductions by using actual expenses. If you go the actual expense route, you also need to figure in all the time it will take you to gather receipts and records.

“The simplified method works well for single-room offices and small operations,” says Tim Gagnon, a public accountant and director of Northeastern University’s online master of science in taxation program. “But if the business spreads throughout the house, or is a large part of the house, the ‘actual expenses’ method will probably obtain more deduction. … It could be worth the effort of gathering, analyzing and separating business use from personal.”

“I’ve calculated the deduction for many clients who have home offices, and the general rule is that they probably shouldn’t bother with the details if they have a small home office” of 100 square feet or less, Turner says.

Things to watch out for

If you plan on deducting actual expenses, it’s a good idea to keep clear, detailed records of all the business expenses you plan on deducting, such as receipts for equipment purchases, electric bills, utility bills and repairs. If you’re ever audited by the IRS, you’ll be prepared to back up your claims.

However, Turner says taxpayers shouldn’t let the fear of an audit keep them from taking the home office deduction.

“I think it’s safe to say the IRS encourages people to be afraid of taking the home office deduction,” Turner says. “In 35 years in business, I’ve had one audit on the home office deduction — this was for a lady who used almost half of her house as an office and got a nice deduction from it every year. We won.”

"For homeowners, there is a potential tax cost to be aware of: taking the home office deduction using the actual-expense method can cancel out your ability to avoid capital tax gains when selling your primary residence", says Craig Smalley, an accountant and financial advisor.

Individuals who sell their primary residence after living in it for at least two of the five years before the sale generally do not have to pay taxes on up to $250,000 in profit on the sale, or $500,000 if married filing jointly, according to IRS Publication 523.

"In order to use the actual expense method of the home office deduction, you have to depreciate your home. Depreciation refers to an income tax deduction that allows taxpayers to recover the costs of property, due to wear and tear, deterioration or obsolescence of the property, according to the IRS. The depreciation you’ve taken in deductions would then become subject to capital gains tax when you sell your home", Smalley says.
“For instance, let’s say you own your home, used 20% of it as your home office and you deduct depreciation. When you sell it, 20% of what you make on the sale is now subject to capital gains tax,” Smalley says. “Taking something that isn’t taxable and making it taxable is nothing I would ever advise my clients to do.”
However, if you use the simplified method, you don’t use depreciation, so you won’t be subject to the tax, according to Smalley. The rules on tax deductions for a home office can get be hard to take in, so consult with a tax advisor or use the appropriate online tax software if you are unsure about how to proceed.

Steve Nicastro is a staff writer covering personal finance for NerdWallet. Follow him on Twitter @StevenNicastro and on Google+.

This post was updated Jan. 7, 2016. It was originally published March 17, 2015.

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