How to Tax-Deduct Home-Office Expenses as a Micro-Entrepreneur
One of the most attractive deductions for micro-entrepreneurs is the home office deduction. Basically the home-office deduction allows micro-entrepreneurs to deduct a portion of their home (whether they rent or own a house or condo) if they regularly and exclusively use it for their home business.
The home-office deduction is easily worth thousands of dollars, so take a close look at it to see whether you qualify. The greatest advantage is that it allows you to make some of your business income tax-free income.
Don’t let an overly conservative tax preparer talk you out of this valuable deduction if you qualify. Keep in mind that literally millions of legitimate home businesses can claim the home office deduction. The IRS even tells you how to do it! The full details are in IRS Publication 587 (Business Use of Your Home).
Can deducting a home office increase your chances of being audited by the IRS? Not necessarily. Literally millions of home businesses legitimately deduct a home office with no issues or problems with the IRS. Keep in mind that the audit rate for small businesses is usually higher than for filers who are W-2 employees anyway because the self-employed have a greater opportunity or temptation to under-report income or over-report deductions.
Your best bet is to be honest and realistic about what is actually the space you’re using for business purposes and carefully document it (such as taking good measurements and taking photos of the office).
Some tax professionals actually advise clients to send in a photo of the home office area in the first year they’re reporting the home office deduction and attaching the photo with the tax return. Consult with your tax professional about your particular situation. Here’s an example:
Say that you’re a renter and you rent a four-room apartment with a monthly rent of $1,000. You use one of those rooms regularly and exclusively for your home business. Assume that you pay $150 per month in utilities.
To complete this example and show you how the home office deduction works, also assume that in this business your net income is $3,000 ($10,000 less $7,000 of regular, deductible business expenses). Keep in mind that for a home-based business, the home office deduction is calculated after regular income and expenses are calculated.
Follow these steps to see how the home office deduction works:
Calculate the total annual rent.
In this example, the monthly rent is $1,000, so the total annual rent is $12,000 (12 × $1,000).
Calculate the total annual utilities.
The monthly utility cost is $150, so the annual utilities cost $1,800.
Combine the total annual rent and utilities expense.
Here the total for rent and utilities is $13,800 ($12,000 plus $1,800).
Take the percentage of living space you use for your home office and multiply it with the total rent and utilities expense.
In this case, you use 25 percent of the living area for a home office (one room out of four rooms). Therefore your home office deduction is $3,450, which is $13,800 ×25 percent.
In this example, assume that the rooms are generally equal. If the rooms aren’t generally equal in size, you’ll then have to measure the total square footage and deduct the business portion. Say that your total living area is 2,000 square feet and the portion that you use regularly and exclusively for your home-based business is 600 square feet.
In that case, the deductible percentage is 30 percent. In other words, you can deduct 30 percent of the rent, utilities, and other expenses that affect the total living area.
Subtract the home office deduction from the net income.
Here the net income was $3,000, so $3,000 – $3,450 offsets the business income. As a result, your net taxable income from your business is zero.
Keep in mind that the $3,000 of business income is cash in your pocket, and the home office deduction of $3,450 made it tax-free. Whether or not you had the home business, you still had to pay the rent and utilities, but now that you have a home business, that home office deduction becomes a powerful tax benefit.
You used only $3,000 of the total home office deduction of $3,450. Unfortunately you can’t use that $450 portion to give you a tax loss. However, you can carry it forward to be used in a later year.
Keep in mind that home office expenses fall into three basic categories:
Fully deductible: If you have an expense that only benefits the home office, then you can deduct 100 percent of that expense. For example, say that you paid $150 to paint only the area that is used regularly and exclusively for your home business. In that case, the full $150 is deductible as a home office expense (on Form 8829 it’s referred to as a direct expense).
Partially deductible: This type of expense is when an expense benefits the entire living area and partially benefits your home office. Say that you’re renting an apartment that is 3,000 square feet, the home office portion is 600 square feet, and you’re painting the entire apartment with a painting bill of $1,000. In this case, only the portion of the painting bill that benefits the home office is deductible.
Because 600 square feet is 20 percent of the total living area of 3,000 square feet, you can deduct 20 percent of the $1,000 painting bill or $200 (on Form 8829 it’s referred to as an indirect expense).
Nondeductible expense: This type of expense benefits your personal living area but doesn’t benefit your home office. Say that your home office is in the basement, but you spend $900 to re-do the upstairs bathroom. In that case, none of the $900 is deductible as a home office expense. For more details, see IRS Publication 587.