One of the most useful and powerful tax deductions for business owners is business use of home (or, as we tax preparers call it, BUOH). If calculated correctly, this deduction will bring down your tax bill and leave some extra cash in your pocket. So, let’s dive in.
Who can take the business use of home deduction?
The good news is that BUOH is an option for anyone – except, of course, for employees (they always seem to get the short end of the stick, don’t they?). Generally, the deduction is most suited for sole proprietors (individuals, who receive forms 1099 and file Schedule C). Partners in partnerships can also take the deduction as an unreimbursed partnership expense on Schedule E. Even S-Corp owners can set up an accountable plan that reimburses shareholders for office expenses. As long as you don’t have W-2 status, the BUOH deduction can work for you.
To claim the BUOH, you need to make sure you meet three IRS requirements:
1. Exclusive use. This means that you ONLY use your office for business. You cannot spend any personal time in the office at all. No eating. No watching TV. Zero. Zilch. Nada. All business.
If you live in a condo or apartment, the courts offer the de minimis personal exception, where the IRS forgives you for occasional instances of personal use. This forgiveness applies to situations where it would be impossible not to walk through the office area. Merely passing through the office on the way to other parts of the apartment would not blow the exclusive-use requirement.
Limited space? Not to worry, the office area does not need to be a separate room. It doesn’t even have to have a door. However, the IRS says that the office area does need to be separately identifiable. It’s always a good idea to make sure the spot is clearly an office and then take some pictures that show how the area contains no signs of personal use. This will protect you in case of an audit.
2. Regular use. Well, this one is pretty self-explanatory. Occasional and incidental work from your office won’t satisfy the requirement. You need to use your office regularly on a daily or weekly basis.
3. The office must be used for one of the following purposes:
- A principal place of business. This requirement is a cinch if you only work from home. But what if you have an office elsewhere? This makes things more complicated and can prevent you from taking the BUOH deduction because your principal place of business is, well, not in your home, right? Yes and no. The workaround here is that you can still qualify for the deduction as long as you perform business administrative tasks (such as billing, e-mailing, and accounting) at your home office and not your outside office. So, bring your administrative tasks home.
- A place to meet customers. Or
- A place used in connection with the business (if the space is a separate structure such as a detached garage or a shed).
One reason you may still want to establish a BUOH even though you have an outside office is that it allows you to business miles. The miles you drive from your home to an outside office are not deductible, as the IRS considers them commuting personal miles. All you have to do in this case is establish a home office (no matter how small), and then your miles become a business deduction. After all, driving from one work location to another is a business expense, right?
Important Note
In most cases, you can’t use your BUOH deduction to decrease your business income to below zero. For example, let’s say your business made $100 and your BUOH deduction is $500. While you could bring down your business income by $100 (making your business income zero), the rest of the deduction will be either lost or carried over to the next year.
Two options for calculating your home office deduction: actual expenses vs. simplified method
Though choosing a method is an important decision, don’t worry: you can switch between methods year to year. For instance, you can use the simplified method one year and actual expenses the next year, then switch back to the simplified method if you prefer.
If you go the actual expenses route, the IRS says you should put your expenses into three buckets:
1. Direct expenses are expenses that relate ONLY to the office and not the rest of the house – for example, painting only the office. These expenses are deductible in full (but still subject to the net income limitation from the disclaimer above).
2. Indirect expenses are expenses that apply to the whole house, like the mortgage or utilities. These are deductible based on the size ratio of the office compared to the whole house.
3. Unrelated expenses are not deductible at all. These include expenses like lawn care and painting rooms other than the office, since they are not connected to your home office work.
The IRS also says that you MUST take a depreciation expense ( of course, if you own a place). Depreciation is calculated over 39 years and is based on either the purchase price or fair market value of the office – whichever is less – at the time home office is established. Depreciation is calculated only if the taxpayer owns a place and only with the actual expenses method. If the taxpayer rents their home, we can instead deduct the rental expense. In this case there is no depreciation because there is not ownership.
If you use the actual expenses method, the unused loss we covered in the disclaimer (read above) gets carried over to future years.
For the simplified method, you don’t need to track actual expenses. All the requirements to qualify for the home office deduction are the same. The main difference is, instead of claiming actual expenses, you will claim $5 per square foot as a deduction on up to 300 square feet of office (for a maximum deduction of $1,500). Just like with the actual expenses method, this deduction cannot add to a loss or create a loss in the business. The simplified method differs in a way that is worth noting: any unused deduction CANNOT be carried over. It is lost forever.
Backend Gotcha for the Actual Expenses Method
Why would someone even consider the simplified method? $1,500 is nothing in this age of inflation and high living expenses. Well, with the simplified method, we don’t calculate depreciation, so there’s no depreciation recapture when the house is sold. What exactly does that mean for you?
If you sell your home and had previously used the actual expenses method, you will pay tax on a gain made from the sale of your home office. This is ordinary income – unrecaptured Section 1250 Gain taxed up to 25 percent! With the simplified method, you don’t need to pay taxes on the sale of your home. This is worth considering, especially if you are taking a big depreciation expense on your home office. The bigger the tax deduction now, the bigger your gain will be when you finally sell your home.
And back to S Corps: if you are an S corp owner, you can't pay for your home office out of the S corp bank account. You must use an accountable plan to reimburse yourself for BUOH expenses. We wrote more about here. Also, the simplified method is not allowed for S Corp owners under Rev. Proc. 2013-13. This means that the S Corp owner must depreciate their house, which will later result in depreciation recapture. The simple workaround here is for the S corp to offer to reimburse the actual out-of-pocket extra costs of working at home. The S Corp can make an allowance for a portion of internet expenses and a company cell phone. Additionally, the employee (or the shareholder) simply makes sure the office space is not 100% solely used for company purposes. For example, accessing personal email or watching Netflix invalidate the business use of home deduction due to the exclusivity rule.
I hope didn’t bore you too much and gave you a good idea of the IRS rules for home office deduction.
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