Calculate Your Home Business Space Deduction
If you have a home business, you want to be able to claim the expenses associated with this business on your tax return. As with a business in any other location, you are allowed to claim a deduction for use of this space on your business tax return.
To qualify for this business tax deduction for your home business, you must meet certain basic requirements. This article explains these requirements, shows you how to calculate the deduction percentage, and details about the specific expenses you can deduct from your taxes if you qualify.
This subject is complicated, and the purpose of this article is to give you a general overview.
First Qualification: Use of the Space
The first thing you must do is to determine if the space for your home business meets IRS requirements: (1) The business must be legitimate; (2) The space must be used as your principal place of business or for specific business purposes, like meeting clients or doing business paperwork, and (3) the space must be used "regularly and exclusively" for business.
Two Methods of Calculating Your Home Business Space Deduction
The IRS allows two different methods of calculating your deduction:
Two Methods of Determining Percentage of Space
To determine which method to use, you will need to know how to calculate the space as a percentage of your home's usable space. The space used for the business is determined by one of two methods:
- Area Method: Divide the area used for your business by the total area of your home. For example, if your home is 2000 square feet and your home office is 400 square feet, your office space is 20% of the total area of your home.
- Number-of-Rooms Method: Divide the number of rooms used for business by the total number of rooms in the home (use this method if the number of rooms is about the same).
In most cases, the area method is the best, since most homes do not have rooms of equal size.
Once you have determined the percentage of space in your home that you can use for calculating home business deductions, the next step is to determine the kinds of home business expenses you can deduct. In addition to your other business expenses, the IRS allows you to deduct expenses that are related to the "business use of your home." If the expenses are not related to your business, you cannot deduct them.
Expenses You Can Deduct Elsewhere on Your Tax Return
Advertising, salaries, and supplies expenses are not deductible as "business use of the home," but they may be deductible elsewhere on your tax return. You might also have a difficult time convincing the IRS that a landscaping service is a legitimate business expense unless you regularly have customers who come to your home for your services.
Be careful to separate business expenses from personal expenses. Then separate expenses into two categories:
Direct expenses are those used only for the business section of your home. An example would be paint, wallpaper, and carpeting used only in that area.
Indirect expenses are those paid for running your home which can be deducted based on the percentage of the home used for business (see "Calculating Your Home Office Space Deduction"). Typical indirect expenses include rent/mortgage interest, utilities, insurance, and general home repairs.
To determine the total indirect expenses, list all of your total home expenses for the year. Here is a partial list:
- Rent or Real estate taxes
- Deductible mortgage interest
- Homeowner's insurance premiums (unless you have separate insurance for the business part of your home)
- Some home repairs (if they affect the home business space)
- Utilities and services, such as electricity, gas, trash, water, and sewer. (Telephone expenses are discussed below)
- Depreciation. To calculate depreciation on your home, use the lesser of (a) the fair market value of your home on the date you first used it for business, or (b) the purchase price (excluding land) plus major improvements minus casualty losses or other changes to your home's basis. Then multiply the amount by the business-use percentage.
Next, deducting home office telephone expenses.
Deducting Telephone Expenses for Your Home Office
If you want to deduct your telephone expenses for your home office, here is what you need to know:
- If you have One Telephone Line in Your Home
If you have only one telephone line in your home, you cannot deduct the use of the phone line for local calls, since that is not "exclusive" use of the line, under IRS regulations. But you can deduct any long-distance business calls you make on the line. Be sure to save your phone receipts so you can show the detail on the specific calls made if you are audited.
- If you have separate business and personal phone lines
If you have set up a separate business line in your home, you can deduct the use of this line for both local and long distance calls. Be sure you do not use this line for personal calls. Remember the "exclusive" provision.
- If you use a cell phone for business
You can deduct expenses for a cell phone used exclusively for business in the same way as a wired phone. If you have only one cell phone and you use it for both business and personal calls, check with your tax adviser on deductibility.
Next, limits on home office deductions.
Limits on Home Office Business Deductions
Even if your home office and the business expenses associated with that office are otherwise deductible, your deductions may be limited, if your gross business income is less than the total amount of your business deductions. From IRS Publication 587 (2007), here is the detail of this limitation:
Your deduction of otherwise nondeductible expenses, such as insurance, utilities, and depreciation (with depreciation taken last) is limited to the gross income from the business use of your home minus the sum of the following:
- The business part of expenses you could deduct even if you did not use your home for business (such as mortgage interest, real estate taxes and casualty and theft losses);
- The business expenses that relate to the business activity in the home (for example, salaries or supplies), but not to the use of the home itself.
Here is an example of how this works:
- First, assume you have met the requirements for claiming a home office deduction (from Page 1) and you have calculated your home office percentage is 20% (from Page 2)
- Your gross business income is $10,000.
- Subtract your deductible mortgage interest percentage for the business, say $1500 ($1500 x 20% = $300). Subtract the business expenses NOT associated with the business use of your home ($4,500, for such items as advertising, travel, and fees for professional advisers).
- $10,000 - $300 -$4500 = $5200. This is the limit to which you can deduct other business expenses associated with the use of your home.
- From this limit you can deduct, first, allowable business expenses associated with the use of your home, then allowable depreciation on your home (based on your office deduction percentage).
If you cannot deduct all of your expenses and depreciation because of the limit, you may be able to carry over some or all of these expenses to the following year. Check with your tax adviser for more details on this carryover allowance.
Note that you can always deduct allowable business expenses not associated with the use of your home, and you can always deduct the business percentage of your mortgage interest. But you will be limited in your ability to deduct other home business expenses, based on your income. For example, if you have a net loss, you will not be able to deduct any home business expenses or depreciation in that year (save your calculations for your tax adviser or preparer).