Heads up: this article is only relevant for U.S. businesses.
When you’re growing a business, it helps to save money where you can. Running your business from home can reduce overhead costs, and it gives you access to the home office deduction.
Home office criteria: passing the IRS test
In order to qualify for the home office deduction, there are three concepts that the IRS is particularly concerned with: exclusivity, regularity, and precedence.
Let’s start with exclusivity. In order to pass the exclusive use test, your working area needs to be used solely for your business activities. The space should be in its own room or identifiably separate area, but “the space does not need to be marked off by a permanent partition.” A corner of your living room that is used entirely for your business activities will pass the test. A desk that doubles as the kitchen table will not. You need to ensure that your work area has clearly identifiable boundaries and that you adhere to them.
The regular use condition stipulates that you need to use your home office regularly (though not necessarily heavily). For example, if you take on a freelance writing contract every few weeks and use your office for the 10 hours that it takes to complete the assignment (and the office sits unused the rest of the time), you probably won’t qualify for the deduction. Conversely, if you run a part-time business from home and you work every Monday and Friday, you would be more likely to qualify. The key is to be using it according to a regular and predictable schedule—even if it’s only three days per week.
The third component to consider is whether you use your home office as the principal place of business. While it’s okay to work out of more than one office, your home office needs to take precedence over other working locations. To decide if your home office passes the principal place test, consider the following: how important are the business activities that you are conducting at each location, and how much time are you spending at each location? You should be spending the most time and conducting the most important business activities out of your home office to qualify for the home office deduction.
Understanding the deductions: direct vs. indirect
Within the home office deduction, the IRS distinguishes between two different types of expenses: direct and indirect.
Direct expenses are solely for the part of your home used for work and include expenses like painting and repairs. These are deductible in full.
Indirect expenses are for the maintenance of your entire home and include expenses such as utilities or insurance. These are deductible based on the percentage of your home that is used for business.
Indirect deductions for homeowners
As a homeowner, you are able to claim a portion of the mortgage interest (not the principal) that you pay on your home against your business. If 10% of your home is used for business, then you would claim 10% of your yearly mortgage interest on Schedule C, and report the remaining 90% on Schedule A.
In addition to claiming a portion of your mortgage interest, you can also take deductions for insurance, repairs, and security (at the same percentage).
If you own your home outright, you can claim a depreciation deduction for the business percentage of your home. Calculating depreciation can be complex, so talking to a tax professional will ensure you’re getting the most out of this option. You can also consult Publication 587 for an IRS guide on deducting depreciation of your home.
Indirect deductions for renters
Renters who qualify for the home office deduction are able to claim the percentage of their rent that is equal to the percentage of their home used for business. For example, if your home office is 10% of your home, then you can deduct 10% of your rent. Renters are also able to deduct the same percentage of their renter’s insurance (if they have it).
How to calculate the home office deduction
The IRS offers two ways to calculate the amount of deductions you can take for your home office: the regular method and the simplified method.
The regular method requires that you calculate the percentage of your home used for business by dividing the area used for business by the total area of your home.
The simplified method allows you to create a standardized deduction of $5 per square foot of home that is used for business, up to a maximum of 300 square feet. This is a good option if you want to skip all of the calculations and worry less about tracking your home office deductions. It may not be the best option if you think your home office deductions would exceed the $1,500 cap ($5 x 300 square feet). Also, the depreciation deduction isn’t an option under the simplified method.
Business mileage: the cherry on top
Arguably the biggest perk of running a home-based business is the ability to claim 100% of the mileage used to get to work sites and do business errands.
The cost of mileage you drive to meet a client on the other side of town is deductible, as is the cost of mileage when you drive to the post office, bank, and any other trips taken for business purposes.
Keep a thorough log of where you were going and the miles you drove, and you’ll have a pretty sweet tax break coming your way when tax season rolls around.