The home office deduction is likely the most misunderstood deduction facing small business owners and freelancers working from home.
The good news is that changes in the tax law in recent years due to the advent of freelancers and home-based businesses have made it easier than ever to claim this deduction. With over 50% of small businesses being home-based according to the SBA, this has now become a popular deduction for many business owners.
According to the IRS, there are two types of home office deductions to choose from: simplified or itemized. Each has its advantages and disadvantages, so make sure to consult a professional CPA to best determine your needs.
The Simplified option for home office deductions reduces the amount of record keeping by prescribing a flat rate per square footage. Currently this rate is $5/square foot with a maximum of 300 square feet.
Itemized deductions demand more work on the bookkeeping side, but have the potential for greater deductions. In this case, all deductions are based on the percentage of your home which is set aside as office space and can include such things as mortgage interest, repairs, insurance, and other expenses.
Regardless of which method you choose, you must qualify for the deduction based on exclusive and frequent use and your home office serving as your principal place of business.
Exclusive Use Test
The biggest roadblock for anyone claiming this deduction is the Exclusive Use test, which states that the area being deducted should be dedicated solely for business purposes at all times. Basically, you must use the office space solely for business and for no other reason. So if your home office is basically your dining room and is used as such for dinnertime, then this area no longer qualifies as a deductible expense.
The exclusive use does not apply to businesses such as home-based child care or which use parts of the home as storage for inventory.
Frequent Use Test
A second thing that must be shown is that the home office is a necessary part of your business and is used frequently. If it is only used sporadically, then it does not meet the requirement for the deduction. Unfortunately, there is no clear guideline as to what constitutes frequent use, so this is handled on a case by case basis if the IRS questions it.
Principal Place of Business Test
The final test for whether or not you qualify for the home office deduction is ensuring that your home office is indeed your principal place of business. It must serve as the sole location of your business, or a primary place to meet with clients and perform administrative duties. If you have a retail store or rent an office space outside the home, then even if you occasionally work from home you are disqualified for the deduction.
While deducting a home office can save small businesses on taxes, there is one caveat. Thankfully, this applies only to those homeowners who are planning on selling their home. In some cases, selling your home may trigger higher capital gains taxes.
Small business owners should take advantage of every opportunity to save on taxes. Freelancers and home-based business owners will find this a worthwhile deduction, but should avoid any potential issues by ensuring that the home office is used exclusively for business purposes and that it the principal place of business.
Want to take some of the stress out of tax planning? Please contact Fusion CPA today to ensure you can claim every deduction which applies to your business.
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