The downside of being self-employed is having to pay your Social Security taxes in full, as opposed to splitting the bill with your employer. The plus side, however, is getting to set your own schedule and, in many cases, work out of your own home. In fact, if you conduct much of your business from home, you may be eligible to claim a home office deduction on your tax return. Here's what you need to know about this somewhat controversial deduction.
Do you qualify for a home office deduction?
The IRS doesn't let just anyone take the home office deduction. To be eligible, you'll need to meet two basic conditions.
First, you must have a dedicated space in your home used solely for business purposes. Though it doesn't need to be a separate room per se, the space you claim as your home office can't serve another function. As an example, if you're a writer and tend to set up shop in your dining room to do your work, you can't take the deduction -- even if you work there almost every day and only use the room for dining purposes once or twice a week.
In addition, the space you claim as your home office must constitute your primary place of business. Now this doesn't mean that you can't do any work elsewhere. It does, however, mean that a good part of your business must be conducted out of your office, and that your office must serve as a centralized location for your business activities. Say you're a marketing consultant who works from home but travels to meet with clients a few times a week. You can take a deduction because your home office still qualifies as your principal place of business.
How to claim the home office deduction
There are two options for taking your home office deduction -- the simplified method, and the standard method. Though the latter is more complicated to calculate, it tends to be the more lucrative of the two.
Under the simplified method, you get to claim $5 per square foot of office space, up to a maximum of 300 square feet, or $1,500. With the standard method, you'll need to tally up your direct and indirect expenses for the year to come up with your deduction.
Direct expenses are those incurred to maintain your office or do your job. For example, if you install new lighting in your office to make it easier to work there, you can deduct that expense in full.
Indirect expenses are those needed to keep your home running, and they include things like homeowners' insurance, property taxes, electricity, gas, water, and sewer service. To calculate your deduction based on these expenses, you'll need to figure out how much space your office takes up relative to the rest of your home and then claim the proportionate amount.
If your office takes up 200 square feet of your 2,000-square-foot home, and you spend $30,000 on eligible home maintenance and repair costs, you can deduct 10% of your total costs, or $3,000, on your taxes. Since you have the option to choose between the simplified and standard method when taking your deduction, it pays to run both calculations to see which benefits you the most.
Be careful with the home office deduction
Because the home office deduction is fairly easy to manipulate, the IRS tends to monitor it closely -- which means that if you use it to pull a fast one on your tax return, there's a good chance you'll get caught. The things you need to be the most careful about are exaggerating your office's square footage and claiming illegitimate expenses. If, for example, you have a 100-square-foot office and you claim that it takes up 250 square feet of space, you could get in trouble if the IRS chooses to look more closely. Similarly, while you're allowed to claim a percentage of home repairs you make during the year, be careful about claiming home improvements that aren't made directly to your office.
You might, for example, get away with claiming a portion of the cost of a standby generator in your home, because although that's an improvement and not a repair, it's also something that ensures you can do your job during a power outage. But if you install a new deck or patio, you'll have a harder time justifying that expense if your office is inside your home.
None of this should be taken to mean that you need to worry about claiming a home office deduction. Just make sure you limit your deduction to legitimate expenditures and keep a record of every expense you claim. This way, you'll have a leg to stand on if the IRS chooses to further investigate.