Self Employed Individuals who report their business activity through a Schedule C may be eligible to deduct expenses related to operating their business out of their home. This is known as the Business Use of Home deduction.
Who Qualifies for the Deduction?
To qualify for the Business Use of Home deduction, taxpayers must be able to show that a portion of their home is:
The Principal Place of Business: This means that this is where you perform your most important business activities on a regular basis and where you spend most of your business activity time.
Used Exclusively for Business: This means that the location within the home is set aside for business use only and is not used for personal purposes. This could be a spare room within your home or a portion of a room that is dedicated to business use.
Taxpayers must be operating a sole proprietorship that reports its business activity on a Schedule C as part of the taxpayer’s individual income tax return. There are also special rules for taxpayers who store inventory within their home or operate a daycare facility.
How Much Can I Deduct?
There are two methods for calculating the Business Use of Home deduction:
Simplified Method
Under the Simplified Method, taxpayers should determine how many square feet of them home are used for business purposes. This can be determined using blueprints or by measuring the space. Taxpayers are then permitted to take a deduction of $5 for every square foot of the home that is being used for business purposes.
Regular Method
The Regular Method requires taxpayers to track expenses both directly and indirectly related to the business use of their home.
Direct Expenses
Direct expenses are any items that benefit only the business part of the home such as making repairs to the home office or painting the space. Any costs associated with furnishing the home office or purchasing supplies are not reported in this section but may be included elsewhere on the return.
Indirect Expenses
Indirect expenses are the costs related to maintaining the home, such as utilities, property taxes, and mortgage interest. To calculate the amount of indirect expenses that are deductible, taxpayers should determine how many square feet of them home are used for business purposes and divide this amount by the total square footage of the home. This represents the percentage of the home that is used for business purposes and should be multiplied by the indirect costs to determine the Business Use of Home Deduction. Taxpayers may also depreciate the portion of the home used for business purposes.
When determining Indirect Expenses, the taxpayer must also determine whether they plan to take the Standard Deduction or Itemize their deductions for the tax year, as this can also impact the amount of Indirect Expenses that may be deductible.
It is important to note that under both methods, the taxpayer may not deduct business expenses in excess of the gross income limitation.
Example
Miguel is a small business owner. His home 2,500 square feet. Miguel uses his home office, which is 250 square feet, regularly and exclusively for business purposes. Based on this information, Miguel determiners that 10% of his home (250/2,500) is used for business purposes.
Miguel has the following Direct Expenses:
Repainting Home Office $300
The full $300 will be deductible as a Business Use of Home expense on Miguel’s tax return.
Miguel has the following Indirect Expenses:
Mortgage Interest $4,500
Real Estate Taxes $1,000
Homeowner’s Insurance $400
Repairs and Maintenance $1,400
Gas and Electric $1,800
Since Miguel Itemizes his deductions, he will report 10% of the mortgage interest and real estate taxes (10% of $5,500 = $550) as a Business Use of Home expense, and will report the remaining 90% as an Itemized deduction on Schedule A.
Miguel will also be able to deduct 10% of the other Indirect Expenses listed (10% of 3,600 = $360) . The remaining 90% of theses costs are non-deductible personal expenses.
Since the Business Use of Home deduction cannot be used to create a business loss, Miguel must also consider his income and expenses related to the business. If Miguel’s business has earned $40,000 this year and incurred $14,450 in expenses (not including the Business Use of Home deduction), then his tentative profit from the business is $25,550. He can deduct the $300 of Direct Expenses and $550 + 360 of Indirect Expenses since these amounts are less than the tentative profit from the business.
Whatever your age or income level, it is never too early to invest in understanding your financial position and setting yourself up for the future. If you’re looking to a professional who can take the complexity and headache out of tax planning, contact us today at kataxandconsulting@gmail.com
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