TIP #4: Home Office... A Tax Deduction Goldmine
One of the least understood tax deductions that many small business owners qualify for is the home office deduction. If you qualify, the home office is a catalyst that can bring you deductions on many things that you never thought possible.
The Quick and Dirty Method
In January 2013, the IRS created a very simple way to claim a home office. You still have to qualify (which we will discuss later), but if you do qualify then you get a deduction of $5/sq. ft. of your home office. (This method is capped at 300 sq. ft. for a total deduction of $1,500.)
Example: If you have one room in your house and it is 12’ x 12’ in dimension then you have 144 sq. ft. Multiply that by $5 per foot and your deduction is $720. Remember the deduction is not cash. To find out the cash savings let’s assume a 35% tax bracket.
$720 x 35% = $252 cash savings
The More Profitable Way to Deduct Your Home Office
Let me show you another way to deduct your home office. It has the same qualification requirements as the quick and dirty method but it is calculated differently and it can be much more profitable.
If you qualify then you can deduct a portion of all expenses relating to your home office including:
- Mortgage interest (The deduction is better as a business deduction than it is as an itemized one on your tax return)
- Rent (if you don’t own your home)
- General repairs
- Lawn care
- Homeowners insurance
- Real estate taxes
- Depreciation of your home
A legitimate home office can also increase your vehicle deductions significantly. I know that seems like it’s unrelated but it’s true. For more information see the chapter on vehicle deductions. But first read on to find out if you qualify for the home office deduction.
Let’s assume that you have a qualified home office (discussed below) that makes up 15% of your total square footage of your home. This means that 15% of many of your current expenses associated with your home can be deducted.
In this case you would get a $2,640 deduction. If you were in the 35% tax bracket then would save you $924 on your tax bill at the end of the year!
$2,640 x 35% tax bracket = $924 cash savings
Every home office is different. You will need to figure this out for yourself by taking the square footage of your home office and divide it by the total square footage of your home.
Home office square footage ÷ Total square footage of home
= home office deduction percentage.
Prove it with a picture. If you get audited, you will have to prove that you had a home office used for business. We suggest you take a picture of your home office and store it in Taxbot for future proof. Make sure you don’t have anything in the office that is not business related.
Let me dispel a myth about claiming a home office. Have you heard that, “claiming a home office is a red flag that will increase your chance of an audit?” I don’t know where this rumor started but it is absolutely not true. One long-term study we participated in showed no significant increase in a chance of an audit when claiming a home office
The One Limitation
One of the bad things about a home office deduction is that it cannot be used in the same year to create a loss in your business. So if your business has a net profit of $2,000 and your home office deduction is $2,400 then you can only use $2,000 of it that year and the other $400 can be carried over to another year.
Do You Qualify?
There are 3 qualifications you must meet in order to qualify for a home office deduction.
- You have a clearly defined portion of the home that you use EXCLUSIVELY for your business. This means you don’t use it for anything else. You can’t use your pool table as your desk in the recreational room unless you never use the pool table except as your desk for business.
- It is your principal place of business. In other words, you do most of your administrative and management tasks from home.
- You work regularly out of your home office. This means you work 4-5 days a week for stretches of 45 minutes to an hour each time. It is very important that you work regularly on your business. The IRS doesn’t like to see someone working 8 hours a day every couple of weeks. They can disallow your deductions and classify you as a hobby instead of a business.
Thus if you have a home based business but only work on it once every couple of weeks, you will not qualify for the home office deduction.
Depreciate Your Home
If you claim a home office you can also depreciate your home office. If you know how much depreciation can be, you know that this could be significant from a tax savings perspective.
It’s true that you will have to pay some tax on any amount that you have depreciated, when you sell your home. For example, if you depreciated $10,000 on your home then you will have to pay taxes on that $10,000 when you sell it.
By depreciating the home office you can invest that money. Chances are you can do better investing that money than you can giving it to the government.
If you don’t understand what depreciation is please talk to an accountant. It is too deep a subject for us to address in this article.