If you run your business from the home, then you may be eligible for the home office deduction, which often results in major tax savings. 

The IRS actually has a broad definition of a “home.”  It can include the following:

• Traditional Home
• Condo
• Apartment (yes, you do not have to be a homeowner to get the deduction)
• Boat
• Mobile Home
• Greenhouse
• Barn
• Unattached Garage
• Guest House

As for the use of the home office, it need not be for a traditional desk, cabinets and computer setup.  For example, the location can be for a sound studio or work area.

In fact, the home office does not have to be a room.  It can actually be part of a room.  One approach is to use room dividers.

Next, you need to meet three threshold requirements:

1.  You Have a Business:  This cannot be a hobby.  But, it is OK for the business to be part-time.

2.  You use the home office exclusively for business:  There may be no personal use for this space.  It’s only for your business.  For example, if you use your kitchen for your cooking business, you will not be able to get the deduction.  The reason is that the kitchen is also used to cook your personal meals.  As a result, it is a good idea to keep only business-related items in your home office. 

3.  You use the home office on a regular basis:  How much?  Unfortunately, the IRS is not clear on this.  Although, based on court cases, it looks like this is a minimum of 12 to 15 hours per week.

If you meet the above three requirements, you still have another hurdle.  That is, you must meet one of the following:

1.  Your Home Is Your Principal Place of Business:  This is the most common one.  In some cases, this requirement is easy (especially for those who do not have another office or do not travel much).

Even if you have other office locations, you can still have your house be the principal place of business.  This is the case if you use it for the majority of your work that results in revenue.

2.  You Do Administrative Work at Your Home:  This is for those business owners who perform much of their work away from the office.  Examples include:

• Traveling salespeople
• Landscapers
• House painters
• Doctors who work at hospitals

So what does “administrative mean”?  This would include:

• Ordering supplies
• Keeping books
• Billing
• Scheduling
• Collecting from customers
• Researching
• Writing Reports

It’s still fine to have some administrative services performed by third-parties (like a payroll provider).

3.  Place for Meeting Customers or Clients:  If your home office is not your principal place of business, it can still qualify for the deduction if you use the location to meet customers or clients.  These meetings must be in-person (not by phone or other form of communication).

These meetings must be on a regular basis.  This may be one to two days per week (but the IRS is not clear-cut on this).  To help substantial this, it is a good idea to log your appointments.

How do you calculate the home office deduction?

To calculate the home office deduction, you need to first determine the amount of space that is used exclusively for business purposes.  There are several of approaches:

1.  Square Footage Method:  You divide the square footage of the office to the total square footage of the home.  Interestingly enough, you can exclude the square footage for common areas, such as stairs, garages, attics, hallways and so on.  This will likely increase the percentage of the office use.

2.  Room Method:  This is allowed if the rooms in your home are roughly all the same size.  Thus, you will divide the number of rooms for business use to the total number of rooms.  You will exclude bathrooms, closets and storage areas.

While the room method usually gives the largest percentage, it is still worth testing both approaches.

What expenses can you take for the home office deduction?

There are two types of expenses you can take for the home office deduction.  They include:

1.  Direct Expenses:  This is an expense solely for the home office.  Examples include:  painting, carpeting, replacing a window and so on.  These expenses are 100% deductible.

2.  Indirect Expenses:  These are expenses for both your home office and personal uses.  For these expenses, you can only deduct the home office percentage (this is the portion of your home used for your home office).

Here are some of the main indirect expenses:

• Rent
• Deductible mortgage interest and property taxes:  The amount you take cannot also be used as an itemized deduction on your Schedule A.
• Utilities:  If your business requires the usage of heavy amounts of electricity, you might be able to deduct more than the business percentage allows.
• Depreciation:  This is allowed if you own the home.  Also, the recovery period is usually 39 years.  To record the depreciation, you will fill out Form 4562.
• Homeowner’s and renter’s insurance
• Home business insurance
• Home maintenance (cleaning, etc):  You can include lawncare if you have customers that come to your home office.
• Casualty losses (damage from storms, earthquakes, floods, theft, etc):  If only the home office is damaged, then the business percentage does not apply.  But you must exclude any amount you get from insurance.
• Condo association fees
• Security system

What is the gross income limit on the home office deduction?

The home office deduction may not exceed the gross income of the business.  This is usually the profit that’s reported on your Schedule C.  But, there may be some adjustment needed, which is done by filling out IRS Form 8829.

However, you can use the excess expenses for future years (there is no limit on this).  In fact, you do not have to remain living in the house.

In other words, even if you cannot get a deduction — because you had a net loss — you should still apply for Form 8829, so you can get the benefit from future deductions.

How to reduce the odds of getting audited for a home office deduction?

Moreover, there are some things to consider to help bolster your case for the deduction:

• Use your home address for key materials, such as advertisements, letterhead and business cards
• Have your business mail sent to the home office
• Try to have clients visit the home office
• Keep a log of activity (customer visits, etc)
• Take pictures of the home office, with date stamps (this could be important if you move out of the home or no longer use the office space)
• Get a dedicated phone line
• Keep receipts for the expenses (utility bills, insurance invoices, mortgage payments and so on)