An In-Depth Look at the Home Office Tax Deduction
How to Start in an Online Business
Support Post for Phase 2 – Step 4
You can view all of my Posts by clicking on the following Link: HelpMeGetMine.com
An In-Depth Look at the Home Office Tax Deduction
Creating an Online Affiliate Marketing Business, allows you to work at home. So, one important task to accomplish is to take An In-Depth Look at the Home Office Tax Deduction and understand exactly how it can benefit you at tax time. Understanding this Deduction is necessary, in order to properly setup a Home Office, as well as, your Books, in order to get the best possible Tax Deductions in this area.
The Home Office Tax Deduction is a Tax Deduction that is allowed by the Federal Government for anyone operating a business out of their home anywhere in the USA. It allows you to Deduct all related Expenses for operating a Home Office.
The types of Deductions that are allowed are:
- Direct Repair Expenses for your Home Office – These may include items such as: wallboard patching and paint, new receptacles and switches, lighting, flooring, shelving, etc.
- Indirect Repair Expenses – These are repairs to your whole house that affect your Home Office. These might include things like: furnace or A/C repairs, roof repairs, outside paint, siding, gutter, and fascia or soffit repairs, etc. Since these types of repairs not only affect your Home Office, but the rest of your house as well, they are only partially deductible, and the deductible amount is based on the size of your Home Office compared to the overall size of your house.
- Equipment, Office Supplies, Furniture, and Fixtures – These would include items such as: computers, printers, office supplies, desk, file cabinet, shelving units, light fixtures, etc.
- Vehicles and related Costs – You can Deduct a portion of all Expenses related to any Vehicles used partially for business use, such as: payments, repairs, insurance, license plates and Vehicle stickers, etc. These deductions are based on the portion of business use of these Vehicles compared to overall usage.
- Utilities – A portion of each of your Utility Bills is deductible, including: gas, electric, water & sewer, garbage, phone, internet, etc.
- Home Mortgage Interest, Taxes, Insurance, and Security – A portion of each of these is deductible, with the deductible amount being based on the size of your Home Office compared to the overall size of your house. If you rent, a portion of your rent is deductible, as well as, renter’s insurance and security related items.
As you can see, the amount of Deductions are enormous, and will benefit you greatly come Income Tax time. There are some that would caution you not to take this Deduction, believing that it will trigger an audit of your taxes. That is simply and completely, not true. I have owned and operated a business out of my home for over 25 years, and I have also done my own taxes for most of those years. I have always taken the Deduction and have never been audited.
Let me insert this: “I am neither a Certified Public Accountant nor a Tax Attorney, and the Federal Tax Laws can be quite complex with many variations based on certain specific circumstances. However, I do have a pretty fair knowledge of the tax laws, and have done my best to simplify things here for the average individual operating an Online Affiliate Marketing Business. However, if you have any questions or concerns about your own particular situation, I would encourage you to consult a CPA, Tax Lawyer, or consult the instructions for the various Forms and Publications published by the IRS to get your questions answered to your satisfaction.”
Requirements for the Home Office Deduction
I have simplified the requirements here, to only pertain to those individuals who own and operate an Online Affiliate Marketing Business. Other requirements and stipulations may apply for those who operate other types of businesses out of their home. I have also included an additional separate Deduction explanation, which applies to those individuals who create and distribute their own products.
Generally, in order for you to be able to take the Home Office Deduction, you must meet certain requirements. You must use part of your home:
- Exclusively and regularly as your principal place of business
- The area used for business can be a room or other separately identifiable space.
- The space does not need to be marked off by a permanent partition (no walls required).
- The space may also be a separate detached structure on you home’s property, such as a shed or converted garage.
- You do not meet the requirements of the exclusive use test if you use the area in question both for business and for personal purposes.
Simply put, you can not use your Home Office for both operating your business as well as for managing your personal home Expenses if you expect to be able to take this Deduction. So, if you want to take this Deduction, make sure that you keep your personal files and your business files in separate locations in your home, as well as work on your personal Expenses in a different area in your home other than your Home Office.
Figuring the Deduction
There are two ways that you can figure your Deduction. You will either use a Simplified Method or your Actual Expenses. It is my suggestion, that for at least the 1st full year you are in business, that you calculate both methods separately and compare the two in order to see which offers you the better Deduction. After that, you can stick with that method unless your situation changes dramatically, which may cause you to recalculate and compare both again. I will now explain the difference in these two methods.
The Simplified Method is an alternative to the calculation, allocation, and substantiation of Actual Expenses. You choose whether or not to figure your Deduction using the Simplified Method each tax year.
In most cases, you will figure your Deduction by multiplying $5 (the current prescribed rate), by the square footage of your Home Office. The Home Office size that you can use to figure your Deduction is limited to a maximum of 300 square feet.
There are also other special circumstances that may reduce or eliminate your Deduction, such as any of the following:
- Not enough business profit.
- Partial year usage
- Shared usage with another business or individual.
If any of these situations apply to you, please review the specifics in the following publication in order to determine if your Deduction is affected: IRS Publication 570
Actual Expenses Method
If you do not or can not elect to use the Simplified Method for a Home Office Deduction, you will figure your Deduction using your Actual Expenses. You will also need to figure the percentage of your home used for business and explore any limits on the Deduction.
You must divide the Expenses of operating your home between personal and business use. The part of a home operating Expense you can use to figure your Deduction depends on both of the following:
- Whether the Expense is direct, indirect, or unrelated.
- The Percentage of your home used for Business.
The explanations of the three types of Expenses are as follows:
Direct Expenses – Deductible in full.
These are Expenses which are only for the business part of your home. These would include items like: paint for your home office, flooring, shelving, decorations, etc.
Indirect Expenses – are only Deductible based on the Percentage of your home used for Business.
These Expenses include those that are for your entire home in order to keep it up and running. They might include things like: real estate taxes, mortgage interest, home insurance, casualty losses, home security system, furnace or air conditioning repair, roof repairs, utilities (electric, gas, phone, garbage, water, etc.), outside house painting, etc.
Unrelated Expenses – are not Deductible.
These are Expenses only for the parts of your home not used for business. They might include items like: kitchen remodeling, family room updating, paint for the living room, etc.
Repairs vs. Permanent Improvements
Whenever you fix or replace something in your home, you need to decide whether the Expense is a Repair or Improvement for Tax purposes. Why is this important? Because you can Deduct the cost of a Repair in a single year, while you have to Depreciate Improvements over as many as 27.5 years.
Example: If you classify a $1,000 Expense as a Repair, you get to Deduct $1,000 this year. If you classify it as an Improvement, you’ll likely have to Depreciate it over 27.5 years and you’ll only get a $35 Deduction this year.
You must carefully distinguish between Repairs and Permanent Improvements. You also must keep accurate Records of these Expenses. These Records will help you decide whether an Expense is a Deductible or a Capital (added to the Basis) Expense. However, if you make Repairs as part of an extensive Remodeling or Restoration of your home, the entire job is a Permanent Improvement.
Example: You buy an older home and fix up two rooms as a beauty salon. You patch the plaster on the ceilings and walls, paint, Repair the floor, install an outside door, and install new wiring, plumbing, and other equipment. Normally, the patching, painting, and floor work are Repairs and the other Expenses are Permanent Improvements.
However, because the work gives your property a new use, the entire Remodeling job is a Permanent Improvement and its cost is added to the Basis of the Property. You can not Deduct any portion of it as a Repair Expense.
Unfortunately, telling the difference between a Repair and an Improvement can be difficult. In attempt to clarify matters, the IRS has issued lengthy regulations explaining how to tell the difference between Repairs and Improvements.
Methods for Calculating Depreciation are detailed thoroughly in: IRS Publication 946, How to Depreciate Property.
Repairs keep your home in good working order over its useful life. Examples of common Repairs are patching walls and floors, painting, wallpapering, repairing roofs and gutters, and mending leaks. However, Repairs are sometimes treated as a Permanent Improvement and are not deductible.
A Permanent Improvement increases the value of property, adds to its life, or gives it a new or different use. Examples of Permanent Improvements are: replacing electric wiring or plumbing, adding a new roof or addition, paneling, or remodeling.
Under the new IRS regulations, property is Improved whenever it undergoes a:
- Adaptation, or
If the need for the Expense was caused by a particular event, for example, a storm, you must compare the property’s condition just before the event and just after the work was done to make your determination. On the other hand, if you’re correcting normal wear and tear to property, you must compare its condition after the last time you corrected normal wear and tear (whether Maintenance or an Improvement) with its condition after the latest work was done. If you’ve never had any work done on the property, use its condition when placed in service as your point of comparison.
Let’s go into greater detail on those three types of Improvements, as follows:
An Expenditure is for a Betterment if it:
- ameliorates a “material condition or defect” in the property that existed before it was acquired or when it was produced. It makes no difference whether or not you were aware of the defect when you acquired the unit of property, or UOP (discussed below).
- results in a “material addition” to the property. Example: physically enlarges, expands, or extends it.
- results in a “material increase” in the property’s capacity, productivity, strength, or quality.
You must also Depreciate amounts you spend to Adapt property to a new or different use. A use is “new or different” if it is not consistent with your “intended ordinary use” of the property when you originally placed it into service.
An Expenditure is a Restoration if it:
- returns a property that has fallen into disrepair to its “ordinarily efficient operating condition”
- rebuilds the property to a like-new condition after the end of its economic useful life, or replaces a major component or substantial structural part of the property
- replaces a component of a property for which the owner has taken a loss, or Repairs damage to a property for which the owner has taken a Basis Adjustment for a Casualty Loss.
What Does the IRS Consider a Unit of Property (UOP)?
To determine whether you’ve Improved your business or rental property, you must determine what the property consists of. The IRS calls this the: ‘unit of property’ (UOP).
How the UOP is defined is crucial. The larger the UOP, the more likely will work done on a component be a Deductible Repair rather than an Improvement that must be Depreciated.
For example, if the UOP for an apartment building is defined as the entire building structure as a whole, you could plausibly claim that replacing the fire escapes is a Repair since it does not seem that significant when compared with the whole building. On the other hand, if the UOP consists of the fire protection system alone, replacing fire escapes would likely be an Improvement.
New IRS regulations require that buildings be divided up into as many as nine different UOPs: the entire structure and up to eight separate building systems. Any Improvement to any of these UOPs must be Depreciated. As a result, more costs will have to be classified as Improvements, rather than Repairs.
UOP #1: The Entire Building
The entire building and its structural components as a whole are a single UOP. A building’s structural components include:
1. Walls, partitions, floors, and ceilings, and any permanent coverings on them, such as:
- paneling or tiling
- windows and doors
- all central air conditioning or heating system components
- plumbing and plumbing fixtures, such as sinks and bathtubs
- electric wiring and lighting fixtures
- stairs, escalators, and elevators
- sprinkler systems
- fire escapes
- other components relating to the operation or maintenance of the building, and
Example: Replacement of a building’s roof is an Improvement to the building UOP.
UOP #2-9: Building Systems
In addition, the following eight building systems are separate UOPs. An Improvement to any one of these systems and must be Depreciated:
2. Heating, ventilation, and air conditioning (“HVAC”) systems: This includes motors, compressors,
boilers, furnace, chillers, pipes, ducts, and radiators.
3. Plumbing systems: This includes pipes, drains, valves, sinks, bathtubs, toilets, water and sanitary sewer
collection equipment, and site utility equipment used to distribute water and waste.
4. Electrical systems: This includes wiring, outlets, junction boxes, lighting fixtures and connectors, and site
utility equipment used to distribute electricity.
5. All escalators.
6. All elevators.
7. Fire-protection and alarm systems: These includes sensing devices, computer controls, sprinkler heads, sprinkler mains, associated piping or plumbing, pumps, visual and audible alarms, alarm control panels, heat and smoke detectors, fire escapes, fire doors, emergency exit lighting and signage, and fire fighting equipment, such as extinguishers and hoses.
8. Security systems: These include window and door locks, security cameras, recorders, monitors, motion
detectors, security lighting, alarm systems, entry and access systems, related junction boxes, associated
wiring and conduit.
9. Gas distribution system: This includes pipes and equipment used to distribute gas to and from the property
line and between buildings.
Example: A landlord purchased an apartment building five years ago for $750,000. This year he spends $5,000 to fix wiring in the electrical system. Under the old IRS rules, the $5,000 likely would be considered a Repair because it is relatively small compared to the overall cost of the building, which was treated as a single UOP. Under the new rules, the electrical system is a separate UOP. This means that the $5,000 must be compared with the cost of the electrical system alone, not the cost of the whole building. This makes the Expense seem much more significant and likely to constitute an Improvement.
For the latest IRS rules on Repairs and Improvements, see: IRS Bulletin 2012-14: Guidance Regarding Deduction and Capitalization of Expenditures Related to Tangible Property.
Calculating your Home Office Business Use Percentage
For your Indirect Expenses, you must first calculate the percentage of your home used for business, before you can add up your Deduction benefits for these.
There are two methods commonly used to calculate the amount of space for your Home Office in order to calculate your Business Use Percentage:
- Measure the square footage of your office, divided by the square footage of your entire home.
Example: If your office is 9’ x 12’ = 108 sq. ft. Your home measures 40’ x 25’ = 2000 sq. ft.
108 divided by 2000 = .054 or 5% for Home Office space.
2. If the rooms in your home are all about the same size or smaller than your Home Office, you can divide the number of rooms used for business by the total number of rooms in your home. If your rooms are not all about the same size or smaller than your Home Office, (within about a 10% variance), then you can not use this method.
Example: Your home has 10 rooms, all about the same size. You use 1 room for Home Office.
1 divided by 10 = .10 or 10% for Home Office space.
Figure Your Deductions
You will soon be creating Spreadsheets which will record all your Deductions. Compare the results of the Total of all of your Actual Expenses to the amount of your Deduction if you use the Simplified Method. Whichever one is larger is the way you should go. You can do this each year and choose the largest Deduction.
There are some Limitations to the Deduction for Home Office. They include, but are not limited to the following:
- Part-Year Use – You can not Deduct Expenses for the business use of your home incurred during any part of the year you did not use your home for business purposes. For example, if you set up your Home Office and begin using that part of your home for business on April 1, and you meet all the tests from that date until the end of the year, you will only be able to Deduct 3/4 of your annual allowable Deduction.
- Limited to Gross Income – Generally, if your Gross Income from the business use of your home equals or exceeds your Total Business Expenses (including depreciation), you can Deduct all your business Expenses related to the use of your home. However, if your Gross Income from the business use of your home is less than your Total Business Expenses, your Deduction for certain Expenses for the business use of your home is Limited.
There are several variances and stipulations if you fall into this area. They include, but are not limited to, the order in which you Deduct your Expenses, as well as what can be Carried Over into the following year should your Profit be in the negative. Be sure to check with a CPA, Tax Lawyer, or review the various IRS Forms and Publications instructions related to this if you have any questions.
Requirements for the Inventory Storage Deduction
For those of you who also create your own products to sell, you can also take a Deduction for using your home to store your inventory. This space is incorporated into your Deduction for your Home Office.
In other words, if your Home Office is a space of 108 sq. ft. and you use part of your basement to store your inventory in, say about 150 sq. ft., then your total Deduction will be based on 258 sq. ft.
You do not have to meet the exclusive use test for the storage of your inventory or product samples. However, you must meet all the following tests:
- You keep the inventory or product samples in your home for use in your trade or business.
- Your home is the only fixed location of your trade or business.
- You use the storage space on a regular basis.
- The space you use is a separately identifiable space suitable for storage.
To clarify, you would be able to take this Deduction, if you use part of your basement to store your inventory, providing that you keep your inventory somewhat separate from your personal items. You might even clean up and use the area that you normally store your inventory in, to host a party and still be able to take this Deduction.
So, in closing, it you use a portion of your home for a Home Office be sure to take this Deduction on your Federal Income Taxes.
Please leave a Comment or ask a Question in the Comments section below.
Continue on to: Formatting Your 1st Spreadsheet – Phase 2 – Step 5
Thanks, and all my best to you in your business.