The COVID-19 pandemic caused an avalanche of people working from home for the first time. We’ve written about the problems and opportunities created by that shift a lot here at The Blueprint. Writers have talked about: tools for working remotely, work from home hacks, and distraction proofing strategies.
All interesting things. Now, it’s time to put on our gloves, get the shovel, and dig into everyone’s favorite topic: tax write-offs.
We’ll go over the home office deduction and talk about who can use it, how to apply it, and how much money you may save.
Overview: What is a home office deduction?
If you own a business and work out of an office or retail building you rent or own, you can claim several deductions to taxable income. You would directly deduct rent or interest paid on debt, utilities, depreciation, insurance, and repairs and maintenance.
The home office deduction allows you to take those same deductions on your tax return if you have a home-based business.
Who qualifies for the home office deduction?
Small business owners and independent contractors with a home business can use the home office deduction to write expenses off of their small business taxes.
Here are the key items to keep in mind if you’re considering using the home office deduction:
- IRS home office rules dictate that the home must be the principal place of business. You can do business elsewhere, but most of it must be done at home.
- When deducting home office expenses, you can use the portion of your house only that is used for the business and, this can’t be stressed enough, you can’t use that area for anything else. The best strategy is to set aside a room to use as an office and keep the door closed when you’re not working. If you have kids, put a sign on the door that says, “Monsters: Keep out!”
Simplified deduction vs. regular expense deduction: Which method is best?
If you have any experience with the IRS, you're probably already leaning toward the simplified method. The IRS definition of regular, especially when it pertains to business taxes, usually means something like 20+ pages of paperwork, months of headaches, pledging of your first born, and threats of voodoo magic.
I recommend calculating your deduction both ways and then choosing whichever approach lets you deduct more. Let’s take a look at how to calculate each.
The simplified method is just that, simple. Calculate the total square footage that you use for business, up to a maximum of 300 square feet, and multiply that by $5. That’s it. I don’t even have to create a graphic on how to do it.
The best way to determine how many square feet you use is to dig out the appraisal that the bank ordered when you bought your house. It should have a breakout of the total square footage of the house and the size of each room. We’ll use the total square footage for the next method.
To use the regular method, calculate the total eligible expenses for your house and then determine the portion of those that are used for the business. If you have a 2,000-square-foot house and use a 400-square-foot room for the business, you would take (400 ÷ 2,000) 20% of the deductible expenses.
Use to calculate the total deductible expenses for your home office tax. This form should be available and easy to figure out on your tax software.
How to determine your home office deduction
Sarah’s Sanguine Salamanders has had a rough go of it. Not many people think of salamanders as good emotional support pets. So, Sarah is still working out of the basement in her home. Her business is a single-member LLC, and she is ready to submit 2019 taxes. Let’s take a look at which method she should use.
Sarah uses more than the max allowed 300 square feet for her office, so she would take the maximum allowable simplified deduction of 300 x $5 = $1,500.
Now consider how much she could deduct using the regular method. Sarah’s household expenses are fairly typical for a house valued at around $350,000.
Depreciation is calculated using the straight line method, and the annual interest was estimated based on an original loan amount of $300,000. If you’re going to use the regular method, keep records (ideally receipts) of your insurance, repairs, and utilities expenses for six years after you file taxes.
Each of those expenses is itemized in the graphic above. Sarah’s house has a total square footage of 2,200, and she uses 500 square feet for her business. This is equal to 22.73% of the total house, so she would be able to expense 22.73% of household expenses.
Unless you’re filing independent contractor taxes for a side hustle and use less than 300 square feet of your home, the regular method will almost always allow you to deduct more than the simplified method.
There’s also the question of the time it takes. If the regular method will likely only allow a few hundred dollars more to be deducted, and you don’t track home expenses religiously, focus on trying to find tax credits instead of calculating depreciation.
What if you're working from home for just a few months?
If you're self-employed, because you own your business or as an independent contractor who receives a 1099 each year, use one of the methods we talked about above to take the home office deduction for the time that you used your home as your principal place of business.
Unfortunately, if you are a W-2 employee working from home because of COVID-19, you are ineligible to use the deduction (unless you have a side hustle where you get a 1099).
Home is where the taxes aren’t
That's obviously wishful thinking, but the home office tax deduction does allow you to reduce the tax burden on your business and make it a little more worth it to work from home during a pandemic — as long as you set strict boundaries for that area.
If you have a side hustle and have been working for 1099 payments, think about dedicating a room just for that work. My wife’s side hustle only took about 25 hours of work each month to complete, but we were able to designate a room as her office and substantially reduce the tax burden of the side job.