Death & Taxes

The Office-in-Home Deduction In Action

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By Roy Lewis
January 26, 2001

In the article entitled "The Office-In-Home Deduction -- An Overview," we discussed the basics of the home office deduction. We'll get into a few more details in this article.

Business percentage
If you are eligible to claim the home office deduction, you'll be required to identify the percentage of personal and business use... called the "business percentage." That percentage will be applied to your home office-related expenses to determine your actual deduction. The business percentage is determined by dividing the area (square footage) exclusively used for business by the total area of the home.

Example #1: Rebecca uses a 10'x10' room (100 square feet) as an office for her business. The total area of her home is 1,000 square feet. Rebecca determines her business percentage by dividing the square footage of the office (100) by the total square footage of her home (1,000). That gives her a business percentage of 10%.

Then Rebecca must determine her home expenses and apply the appropriate percentage to determine her deduction. But, not in all cases. In some cases, Rebecca might receive 100% of the office expenses paid and not have to apply the business percentage to them. How so? Well, there are really two types of expenses applicable to the home:

Direct Expenses: These are expenses that benefit only the business part of the home. They would include things like painting or repairs made only to the specific area or room used for business. Because these expenses are made specifically for the office, they are 100% deductible. You're not required to reduce those expenses by the business use percentage.

Indirect Expenses: These expenses benefit both the business and personal parts of the home. Included are the upkeep and running of the entire home. This would include expenses such as property insurance, property interest and taxes, rent (if you don't own your home), repairs, utilities, depreciation, and the like.

Sadly, many people think that all of the indirect expenses in every case will be deductible based on the business percentage, but this simply isn't true. In some cases, the business percentage of an indirect expense might be different from the overall business percentage computed.

Example #2: Rebecca uses her home 10% for business. Her electric bill is $800 per year, but that electric bill includes the charges for lighting, cooking, laundry, and her TV. Assuming that cooking, laundry, and TV have nothing to do with her business, she'll be required to reduce her total electric bill by the charges not applicable to her business. Rebecca believes that a reasonable estimate for lighting only amounts to $300 (of the total $800 bill). She'll then use that $300 as a basis for her total electric indirect expense. That would make her deductible electric bill applicable to the home office $30 ($300 X the 10% business-use percentage).

It's not within the scope of this article to discuss depreciation, because it has its own rules and regulations. But suffice it to say that depreciation is a component of indirect expenses. So, if you want to get the maximum bang for your home office buck, don't forget to compute depreciation for your home.

You can read more about depreciation in IRS Publication 946. But, remember one thing about depreciation: If you take the home office deduction, you're required to compute depreciation on the property... even if you might not want to. Any depreciation claimed will be "recaptured" and subject to tax when the property is sold. That's not necessarily a bad thing, because the tax savings might outweigh the future tax that will be recaptured. But before you claim the home office deduction, make sure you understand how the depreciation recapture rules actually work.

Don't Double Dip!
Another misconception about the office-in-home deduction is that you can claim your property taxes and mortgage interest twice: once on Schedule A (with your itemized deductions) and again on Form 8829 (for your home office expenses). Wrongo!! Mortgage interest and property tax deductions claimed as a home office expense can't be claimed again on Schedule A.

Example #3: Let's look at Rebecca again (isn't she smart?). She paid $12,000 in mortgage interest and $1,500 in property taxes for the year. Her business use percentage is 10%. Therefore, $1,200 of the mortgage interest and $150 of the property taxes are deducted on Form 8829. Rebecca can only claim as an itemized deduction on Schedule A the amount of mortgage interest ($10,800) and property taxes ($1,350) that were not claimed on Form 8829. This is one of the most common mistakes made by folks claiming the home office deduction -- and one of the reasons that Uncle Sammy scrutinizes home office deductions closely. Don't let this happen to you.

Putting it all together
Example #4: Let's bother Rebecca one last time. She also determines that her property insurance is $900 for the year; the monitoring fee for her security service (which secures the entire home) amounted to $320; she paid her pool service $500 for the year to clean the swimming pool; she repaired a faulty electric outlet in her home office for $75; she also paid other general household repairs of $1,750; and she determined that the total depreciation on the property amounted to $3,500. From the examples that we've already discussed and this additional information, what is Rebecca's office-in-home deduction?

  • Utilities ($800 total, but only $300 applicable to lighting for the property) x 10% = $30
  • Mortgage Interest of $12,000 x 10% = $1,200
  • Property Taxes of $1,500 x 10% = $150
  • Property Insurance of $900 x 10% = $90
  • Security monitor fee of $320 x 10% = $32
  • Electric outlet repair of $75 x 100% = $75 (remember, since this expense applied specifically and only to the office, it's 100% deductible, and the expense does not have to be reduced by the business percentage. This is a direct expense!)
  • General repairs of $1,750 x 10% = $175
  • Depreciation of $3,500 x 10% = $350

    Add 'em all up, and you should arrive at a total deduction of $2,102. What happened to the expense for the pool cleaning service? Well, since the pool isn't used for business purposes, those expenses aren't applicable at all for the home office computations... either in whole or in part. So, don't even think about taking 'em (another reason the IRS looks at the home office deduction closely). IRS Form 8829 will help you walk through these computations.

    Inventory storage and daycare facilities
    Remember that to qualify for the home office deduction the business portion must be used exclusively for business. But, there are two exceptions: storage of inventory and daycare facilities. That only makes sense. If you think about it, in either case, it would be virtually impossible to use the business area "exclusively" for business. So if you store inventory or produce samples, you might qualify for the home office deduction if you meet all of the other tests and:

    1. The business is a wholesale or retail business
    2. The home is the only fixed location of the business
    3. The storage space is used on a regular basis
    4. The space used can be separately identified

    With respect to a daycare facility, you are able to deduct a portion of the home, even if it's not set aside exclusively for the business. A room can be a living room at night, and a playroom by day. For daycare facilities, you must compute a business use percentage and also make an additional computation for the percentage of time devoted to the daycare activity. If you do have a daycare facility in your home, IRS Publication 587 is required reading.

    Sale of the property
    Remember that, with the new laws regarding the exclusion of gain on the sale of a personal residence (up to $500,000 of gain for married folks), taking the office-in-home deduction might cause you to pay some unwanted taxes in the future. If you claim the home office deduction, not only will you be required to recapture (and pay taxes on) depreciation claimed in the past, but you might also be taxed on the gain (if any) relative to the business portion of the home. If you sell your home, your home office is no longer treated entirely as part of your home. Part of your home will be an office, and the sale of an office is not subject to the gain exclusion provisions.

    So, if you're thinking about selling your home, you might want to think twice about claiming the office-in-home deduction. Or at least make sure that you don't qualify for the deduction in the year that the home is sold.

    For more examples of the office-in-home deduction in action, check out "The Office-In-Home Deduction -- Examples."

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