Most Americans have traditionally worked in a setting outside of their home, whether they’re an employee or a business owner. But some individuals work from home—and with an increasing percentage of the workforce made up of freelance workers and gig workers, it’s likely that more and more taxpayers will be looking into how to calculate a home office deduction.
The way in which you calculate a home office deduction depends on what type of working arrangement you have at home. Here are a few guidelines to consider when calculating your home office deduction:
How to Calculate a Home Office Deduction
- Meet Space Qualification
- Simplified Method Calculations
- Detailed Method Calculations
It’s important to realize that the home office deduction can only be used by individuals who are self employed, which includes business owners, freelance workers, and gig workers who are working for profit. Examples of such individuals might include an insurance agent or real estate agent who conducts sales calls and sends emails from a dedicated workspace, or a graphic designer who builds websites for clients at a desk in their living room.
Employees of a company who work from home are not eligible for the home office deduction because it’s a business deduction—and (in most cases) employees on a payroll do not own the business they work for. Examples of these individuals might include someone who fields customer service calls and is paid on a payroll, not as an independent contractor. Independent contractors are effectively self employed, but employees on a payroll receive a W2 and cannot claim business expenses against their wages.
Tangentially, if a company or business paid rent or mortgage on a place of business and had other operating expenses associated with running the business at that location, they would deduct those expenses from their corporate taxes or business taxes, but individual employees would not relate to that concern, as they are not responsible for those expenses.
It is true that employed individuals used to be able to claim a home office deduction on their tax return under the miscellaneous deduction for unreimbursed business expenses, but that was eliminated in 2018 and moving forward.
If you are employed but also run a for-profit business from your home, you should speak to your tax advisor about how to make the home office deduction when you file your taxes. Many self employed taxpayers engaged in a side hustle, such as selling items on Amazon, are not taking advantage of a taxpayer benefit like a home office expense.
What Is the Standard Home Office Deduction?
The standard home office deduction is part of the simplified method of accounting for a home office deduction. It is $5 per square foot, up to 300 square feet. This means that a self employed individual or independent contractor working from home could claim a deduction of up to $1,500 per taxable year.
If you’re wondering how much 300 square feet is exactly, it’s comparable to a space of 20 feet by 15 feet—which is a pretty sizable space. For readers who are not home builders or architects, the average American bedroom is 11 ft by 12 ft, a much smaller space than the maximum allotted size for a standard home office deduction.
Many self employed individuals work with a phone, computer, and little else in terms of what might take up space, so the 300 square foot maximum allotment is quite generous. However, some self employed individuals may carry inventory, for example, if they engage in online retail. If the amount of inventory or business equipment needed exceeds 300 square feet, these individuals should look into additional possibilities with their tax advisor for other workspace related deductions they can make as business expenses—such as renting space in a warehouse and itemizing that rental deduction.
How to Calculate Home Office Deduction
Meet Space Qualification
Before taking a home office deduction from your taxable income, you need to make sure you meet the requirements of the IRS for doing so.
Here are the requirements that a self employed individual will need to meet:
The intention of your business activities must be for profit—This requirement is meant to filter out individuals pursuing a hobby at home and hoping to take it off their taxes. The requirement relates to intention, not profit, so you will meet this requirement even if your business is not generating as much income as you’d like. To provide an example, let’s take someone who engages in woodworking. If they have turned their garage into a woodworking studio and craft items they give away to friends and family, that does not count as a for-profit business. However, if they sell handcrafted items on Etsy or at a local farmer’s market, that would count as a business activity with for-profit intentions.
The home office must be your principal place of business—Meeting clients, calling clients, or doing paperwork all count as business activities if they take place in the home office space. However, if you do these activities at home in the evening, and your principal place of business is an office or storefront that you rent, you will likely not be able to consider your home office as your principal place of business. Keep in mind that the principal place of business is established by the hierarchy of activities in terms of importance and time spent. If, for instance, you are a real estate agent, you probably spend a large amount of time outside of your home, showing properties to clients. And yet, your home workspace could still count as a principal place of business if that is the space from which you make cold calls, send emails, and arrange appointments. This is because these are the activities that are at the core of driving business, and it’s likely that no one property you visit with clients will be frequented more than the space you use at home to work.
The home office workspace must be used regularly and exclusively for work—This precludes occasionally burning the midnight oil at the kitchen table, since that space is most likely also used for eating, and a one-off intense project requiring excess hours is not a regular activity of employment. At the same time, you will have to use some discretion to determine the parameters around this condition. For example, you may not have a dedicated work space in your home, and may in fact use the kitchen table regularly, every day, between certain hours, for work. Speak to the advisor in charge of your tax planning if you have any questions or would like to discuss the limits of your home office space.
If you meet the requirements for a home office space, then you can turn to one of two accounting methods for your home office deduction. The first is the simplified method, which is also called the standard home office deduction. This method allows you to calculate a deduction based on the formula of $5 per square foot, up to 300 square feet, for a maximum deduction of $1,500.
It’s important to note that with the simplified method, you cannot also claim a home depreciation deduction or recapture depreciation for any year in which you use the simplified method. However, for most taxpayers, the simplified method offers an easy, headache-free way to calculate their home office deduction. Moreover, recapture depreciation (or depreciation recapture) relates to reporting income from the sale of an asset (in this case, your home office). This means you cannot work from home all year, and then (if you sold your home) also claim the depreciation recapture in your income. You also cannot use the home office deduction as a business loss if you use the simplified method.
An alternative to the simplified method is the detailed method, which is a little more involved in terms of calculating the deduction. These calculations must be detailed on IRS Form 8829 and included with your business tax return. There are two ways to perform the detailed method:
The area method involves dividing the area used for your home office by the total square footage of your home. This method is advantageous to individuals whose work from home activities truly encompass more than the 300 square feet of space allocated by the IRS to individuals using the simplified method.
For example, if you run an in-home daycare in a 500-square-foot space and the total square footage of your home is 2,000 square feett, you are looking at 25 percent of your home as a home office space. Tangentially, it’s important to keep in mind that there are other considerations than business taxes when it comes to running a business (like a daycare or a woodworking shop) out of your home. This includes licensing and insurance—but those concerns are beyond the scope of this article.
Number of Rooms Method
The number of rooms method involves dividing the number of rooms used for business by the number of rooms in your home.
Let’s say you run a hair salon on the ground floor of your home, and there are three rooms involved—a waiting room, a bathroom, and the salon itself. If there are ten rooms in the home, you are looking at a 30 percent ratio. Again, this method is advantageous for self employed individuals whose business activities expand beyond the 300 square foot allotment accounted for by the simplified method; especially for individuals with a business that requires multiple rooms. However, it’s important to remember that (1) these rooms truly must be used regularly and exclusively for your business and (2) you should remember that there are other legal concerns to keep in mind, such as insurance and licensing.
Write this percentage down because you will need it to calculate your exact home office deduction.
Home Office Expenses
Next you will need to itemize your home office expenses, which are separate from your business expenses in that they specifically relate to the cost of running your home office.
A direct expense is an expense that only relates to the part of the home you run your business. Examples of a direct home office expense might include paint, flooring, and repairs.
An indirect expense relates to the cost of living in your home overall, not just your workspace. This can include things such as a rent or mortgage, property taxes, HOA fees, homeowner’s insurance, home renovations or repairs that impact the work space (such as cleaning the HVAC or plumbing repairs), utilities and services (like electric, heat, water, sewage, and internet), and depreciation. You should consult with a. firm that provides tax services to discuss how to calculate the depreciation of your home. Generally speaking, it is found by dividing its value by 27.5 years, but there are other formulas that can be used.
Once those expenses (both direct and indirect) have been added up, you will multiply the dollar amount by the percentage you calculated earlier, using either the area method or the number of rooms method.
One last thing to note is that when calculating indirect expenses, you cannot factor in renovations that do not impact the workspace. For example, building a deck or expanding your kitchen with a breakfast nook and bay-view window cannot count towards your home office unless you have a good argument that it was a necessary improvement for the business (an example would be if you are a social media influencer and film a cooking segment out of your kitchen).
Home Office Deduction Calculation Examples
Let’s calculate the home office deduction of a small, home-based bridal gown retailer as an example. This small business owner has a portion of their home dedicated to selling bridal gowns—this includes a small fitting room and a separate room for storing gowns. The gross income from this activity is $20,000 annually, which supplements the salaried income from their spouse.
According to the detailed method of making a home office tax deduction (specifically the area method), they are looking at 1,000 square feet of home space dedicated to a business purpose. Let’s also say that their entire home is 2,500 square feet. This would result in a 40 percent ratio.
In terms of direct expenses, let’s say that this small business owner needed to install new carpet and paint the walls of the fitting room in order to give it a more trendy look. This resulted in close to $1,000 in renovations and contracting work.
In terms of an indirect expense, this small business owner would look at items like mortgage and mortgage interest, real estate tax, and utilities. For the sake of a simplified example, these concerns add up to around $15,000 annually.
Added together, the direct expenses and indirect expenses come to $16,000. One would then take the 40% ratio found earlier and multiply it against the expenses, resulting in a dollar amount of $6,400.
The small business owner could then reduce the taxable burden of their annual gross income of $20,000 (for their small business activity) down to $13,600, resulting in some serious tax savings. For a self employed individual whose entire gross income is generated from self-employment or a small business, the savings would be that much greater.
Let’s also examine what would happen to the same small business owner if they used the number of rooms method, assuming the direct and indirect expenses are the same. If their 2,500 square foot home has 10 rooms total, the two rooms dedicated to business activity would comprise of just 20 percent of their home.
Repeating the calculations, this would result in reducing their taxable income to $16,000. This is a larger tax burden than the $13,600 they could obtain by using the area method. Though the $2,400 difference may not seem like much in the grand scheme of things, the difference could become much larger if the income is significantly higher. This is why it’s important for a small business owner or self employed individual familiarize themselves with how to calculate home office deductions.
If the business owner had used the standard method to calculate their home office duction, they would only be able to claim $1,500, maximum. This further illustrates why the detailed method can be much more advantageous to small business owners whose business takes up more than 300-square-feet of their home.
How to Claim a Home Office Deduction?
If you are using the simplified method, you will list it on your Schedule C, which is also called Form 1040 or 1040-SR. This sheet lists the profits and losses from your business or self-employment activity.
If you are using the detailed method, the number obtained from these calculations will also go on the Schedule C, but the calculation itself must be tabulated on a separate Form 8829. While most tax software is equipped to add these numbers to the proper forms, it’s best to consult with a tax expert to ensure you’re getting the full and correct deduction.
Home Office Deductions Reduce Your Company’s Tax Liability
The home office deduction is a great way for small business owners or self employed individuals to reduce their tax burden and claim some of the business expenses that are inevitably associated with running a business—such as having a workspace in which to conduct business.
While the simplified method will suffice for most individuals who conduct their business using a computer and phone on a small desk, the detailed method is much better for individuals whose business activities take up a larger amount of space.
As of 2018, the home office tax deduction is only available to independent contractors and those who are truly self employed or run a business—those who fill out a Form 1040 or Schedule C. Those who only receive a W2 and wages from an employer cannot claim this deduction, even if they work from home.
Speak to your tax advisor to determine if you’re a qualifying taxpayer for the home office deduction, and if so, how much you can legally claim. If you don’t yet have one of those, one of the Anderson Advisors tax professionals would be happy to consult with you! You might also consider joining our weekly Tax Tuesdays webinar for more tips and deductions to save money on taxes.