(NOTE: This is a continuation of a case study looking into tax implications of starting up a small business. This particular article deals with tax deductions for small business. Click here to go back to the start of the case study.)
With her nail business ramping up, Amy cleans out a spare bedroom in her house and turns it into an office. Looking around the room, she wonders whether the space can be deducted.
After all the work of getting the office set up, she decides to treat herself to a Bacon Maple Bar at Voodoo Donuts. While waiting in the Disneylandesque line, she runs into her accountant, who is just walking out with a box of “Captain my Captain” donuts.
After a brief chat about the location and whether the neighboring dispensary has seen an uptick in business since the donut shop opening, the real conversation starts: what kind of home office expense deduction can Amy take?
Potentially Troublesome Requirements
The Home Office Expense Deduction is one of those “high audit risk” items, so you really need to make sure you have your ducks in a row before you take the deduction. The key is that a portion of your house must be used EXCLUSIVELY on a regular basis for your business.
That means if you plan to use your office for business during the day and a gaming den at night, you will not be allowed to take the deduction. The exception to this is if you use a portion of your home as a daycare facility for only part of the day you can still take the deduction, but you must have a license to run a daycare home under your state’s law.
For those of you who work for an employer, you have an extra requirement to qualify for the home office expense deduction: in addition to the exclusive use requirement, you also have to be working from home at the convenience of your EMPLOYER. So, if your boss ran out of space in the building and asks you to work from home, you can qualify for the deduction (though, again, the office still needs to be 100% business use). If, however, you thought it would be nice to work from home and convince your boss to let you, it is for your convenience and, therefore, NOT deductible.
Assuming you are willing to rope off that extra room from your kids homework efforts (or Minecraft addiction), there’s two methods to take that Home Office Expense Deduction. The first is the Simplified Method.
To take this deduction, all you have to do is determine how many square feet you’ve dedicated to your office (up to 300 square feet maximum) and multiply it by $5. There are some limitations to make sure the home office expense deduction doesn’t give you a loss, but the general rule is just that simple.
If you’ve dedicated various amounts of square feet to your office throughout the year, all you have to do is take the average. Let’s say you started your home office in May with 150 square feet, then increased it to 500 square feet in November (which is limited to 300 square feet). You’d do the following calculation (0+0+0+0+150+150+150+150+150+150+300+300)/12 = 125. Multiply the 125 by $5 to get a total deduction of $625.
Stick this amount on 1040 Schedule C Line 30 (as of the 2013 form), and you’re done.
Once your home office starts getting bigger than 300 square feet, or your total related expenses get over $1,500, it make sense to do the extra work of the regular method for the Home Office Expense Deduction. It’s more complex, but the required Form 8829 will guide you through it.
The basic idea of the regular method is the same as the simplified method: figure out the total square feet of your house and how many square feet you’ve dedicated to your business. Once you do that, divide the business square feet by the total square feet and come up with a percentage.
Example: I have a 2,000 square foot house. Of it, I dedicate 500 square feet to my business. That gives me a ratio of 25%.
Next, figure out the expenses related to your home. Form 8829 Part II gives a good list of the typical expenses, including mortgage interest expense, real estate taxes, insurance, rent, repairs and maintenance, utilities, etc.
If an expense was directly related to the office, put it in Column A of Form 8829 Part II. A direct expense would be something paid just for the office, like if you had to repair a hole in the office wall. I wouldn’t expect too many items to be considered direct expenses.
Most items will be indirect expenses. These are calculated by taking the total expense and multiplying it by the ratio calculated above. For our example, if I paid $1,500 in real estate taxes during the year, I would allocate 25%, or $375, as an indirect expense.
You’d do the same calculation for things like insurance, utilities, mortgage interest, etc. since all of them are paid for the overall house then allocated in part to the office.
Finally, you can actually depreciate the office, but I would highly recommend against this. If you choose to depreciate, you’d take the smaller of the adjusted basis of your home or the fair market value. You’d then multiply that amount by the percentage dedicated to the office and deduct about 2.5% of the resulting value over the next 39 years (the actual amount depends on the month you placed it in service. A table is found in Form 8829 instructions for Line 40 as of writing).
In the example above, if I bought my house for $200,000, and the Fair Market Value is $250,000, I would multiply $200,000 x 25% = $50,000. I would then pull up the table found on Form 8829. If I placed this office in service in May, I would multiply $50,000 x 1.605%, which would give me $802.5 deduction the first year. Every year after that I would get another $1,282 deduction.
The amount of the deduction isn’t too shabby; however, I have to track the depreciation, which goes against the value of my home. If I were to sell my house after that first year of depreciation, instead of using $200,000 for the basis, I would use $198,800. And it would keep going down the more you depreciate. And, even worse, when you go to sell the house, assuming you sell it at a gain, you’d have to “recapture” your depreciation, which means you’d have to pay ordinary taxes on that depreciation amount, basically paying the IRS back for the years they allowed you to depreciate your office.
It ends up being a large hassle, and also puts you higher on the list for getting a friendly IRS audit.
After you’ve calculated all of these expenses, you total it up, and it goes over to the Form 1040 Schedule C Line 30 (again, as of the 2013 forms).
As noted in the Simplified Method, the Regular Method also cannot create a loss for your business. If this deduction moves your business from income to loss, you’re limited in your deduction, though you can carry forward the difference to future years.
The home office expense deduction can offer a bit of a boost to your tax deduction as long as your willing to sacrifice an area of your house to be used 100% by your business. If this is the case, I would certainly recommend taking the Simplified Method or deducting the utilities and other expenses on your house. I would not, however, recommend treading into depreciation territory. It generally ends up making a mess.
Amy’s accountant looks down at the box in his hands. In the amount of time it took to explain all of this, he realizes he ate all of the donuts in his little pink box. “Ah crap. I’m going to have to get back in line.” He looks at the line wrapping almost around the end of the block. “Or maybe I’ll just get my family Dunkin’. They probably won’t know the difference”
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