Although everyone uses the shorthand “home-office deduction” to refer to amounts that you can claim if you operate your business from your home, it is important to realize that the home-office deduction is actually many deductions for different types of expenses.
Frankly speaking, you get to put into consideration such expenses as mortgage interest, property taxes, and homeowner’s insurance. Along the line, you also have to depreciate a percentage of the home. If you meet certain guidelines, the sale of your personal home is excluded from the capital-gains tax. If you depreciate your home and call it business property, the exclusion does not cover the portion that was used for transacting business, and a percentage of the sale of the taxpayer’s home is now subject to capital-gains tax. However, in 2013, the IRS instituted the simplified method for determining the home-office deduction, which took capital-gains tax off the table.
The common denominator among these deductions is that the IRS has devised a single test to determine whether you qualify for all of them. If your working space doesn’t meet the “home-office test,” these expenses are either nondeductible personal expenses (such as rent, painting the room, or repairing the furnace) or deductible only as itemized deductions (such as mortgage interest or real-estate taxes).
If you would be entitled to claim an itemized deduction for an expense related to your home, you can claim that without regard to the home-office deduction rules. For example, home mortgage interest and real-estate taxes would be allowed as an itemized deduction on Schedule A of your tax return in any case, even if you can’t take a home-office deduction.
Although everyone uses the shorthand “home-office deduction” to refer to amounts that you can claim if you operate your business from your home, it is important to realize that the home-office deduction is actually many deductions for different types of expenses.
Frankly speaking, you get to put into consideration such expenses as mortgage interest, property taxes, and homeowner’s insurance. Along the line, you also have to depreciate a percentage of the home. If you meet certain guidelines, the sale of your personal home is excluded from the capital-gains tax. If you depreciate your home and call it business property, the exclusion does not cover the portion that was used for transacting business, and a percentage of the sale of the taxpayer’s home is now subject to capital-gains tax. However, in 2013, the IRS instituted the simplified method for determining the home-office deduction, which took capital-gains tax off the table.
The common denominator among these deductions is that the IRS has devised a single test to determine whether you qualify for all of them. If your working space doesn’t meet the “home-office test,” these expenses are either nondeductible personal expenses (such as rent, painting the room, or repairing the furnace) or deductible only as itemized deductions (such as mortgage interest or real-estate taxes).
If you would be entitled to claim an itemized deduction for an expense related to your home, you can claim that without regard to the home-office deduction rules. For example, home mortgage interest and real-estate taxes would be allowed as an itemized deduction on Schedule A of your tax return in any case, even if you can’t take a home-office deduction.
The advantage of the home-office deduction is that the portion of these expenses that relate to the home office can be deducted as “business expenses” in arriving at your gross income, which provides a much more substantial tax break.
Regular Method vs. Simplified Method
Around 2012, the home-office deduction worked like this: You would take the square footage of the portion of the home that you use as an office and divide it by the total number of square footage. This would result in the “business use” of the home. As a rightful owner of your home, you would cater for some expenses, like mortgage interest, property taxes, homeowner’s insurance, depreciation, and electricity, at the percentage of the business portion of the home, and that would amount to being above-the-line deductions.
For instance, let’s assume the basis of your home expenses is grossly $350,000, and you use 20 percent of the home expenses for business. If 20 percent of $350,000 was depreciated, you would have successfully depreciated $70,000 of the home. Roughly, your depreciation per year would be $1,795. Also, if your deduction was at the 15 percent tax bracket, your tax deduction would automatically be $269; at the 25 percent tax bracket, it would be $449; at 28 percent, it would be $503; at 31 percent, it would be $556; at 35 percent, it would be $628; and at 39.6 percent, it would be $711.
Now, peradventure deduction was taken for five years, and you sold the property for $500,000. The sale would be tax-free, but you’ve designated 20 percent of the home as business property, so when you sell the home, $30,000 would be subjected to capital-gains tax. If your capital-gains tax rate was 15 percent, your tax would be $4,500, and if your capital-gains tax was 20 percent, your tax would be $6,000. We haven’t even said anything about the 3.8 percent net investment income tax, which would be due on the capital gain if your income was more than $250,000. Anytime you possess an asset that isn’t taxable and make it taxable, it is not so ideal.
Under the simplified option, the standard deduction is $5 per square foot, up to 300 square feet of office space used, capped at $1,500 per year. The deduction that you take with the simplified option cannot exceed more than the gross income for business use of the home and less business expenses. Interestingly, you don’t have to recapture any depreciation on the sale of the home.