Tax Insight

Business Use of the Home – Part 3 – What you can deduct.

(This is Part 3 of a four-part series. Read Part 1 and Part 2 first.)

Once you have determined that you are eligible to claim expenses related to the business use of your home, the next step is to determine which expenses are deductible, and to what extent.  In making this determination, there are three potential categories into which each expense will fall:

• Directly related expenses
• Indirectly related expenses
• Unrelated expense

Directly related expenses are those expenses that only benefit the business-use portion of the home.  Examples of this type of expense would be improvements or repairs to the specific room that is used for the business, or additional insurance on the business property in that room.

Example:   The improvements that Mike made to the shed in his backyard, when he converted it to a workshop, would be directly related to the business because they did not benefit any other part of the house.  For this reason they would be fully deductible business expenses.

Tip: Whenever possible, separate out receipts and bills into business and non-business portions.  For example, if you will be having the inside of your entire home painted, ask the contractor to specifically separate on the bill, or on separate bills, the cost for painting the home office.  In this way you will have a clear way to distinguish the business-use expense, and will be able to count it as a fully-deductible business expense.

Indirectly related expenses are those that benefit both the business and non-business portions of the home.  Some examples of this would be the cost of utilities, repairs to the roof, mortgage interest, insurance or real estate taxes.  These are things that can’t easily be divided between the personal and business portions of the home.

Generally, these types of expenses will be deducted proportionately to the amount of space used in the home.  So, if the home office is 250 square feet, and the home is 2,500 square feet, 10% of indirect expenses will be deductible (250 / 2,500 = 10%).  However, there are certain expenses that may be treated differently than by this general rule.

One indirect expense that may receive special treatment is utilities.  If the nature of the business lends itself to using a disproportionately high or low percentage of the utilities, the amount deducted should be adjusted to reflect the actual usage.

Example:  The tools that Mike has in his workshop use a lot of electricity.  In fact, based on the difference in his electric bill between months when he is spending a lot of time making crafts, and those when he is not, he estimates that 35% of his annual electric usage is related to the workshop.  While the shop only makes up about 8% of his home’s total square footage (by combining the sq. ft. of the shed and home together), he will deduct 35% of the electricity bill for tax purposes.

On the other hand, he really doesn’t use any water for his business.  Practically all of the water used at his home is for personal reasons.  Because of this he would not deduct any portion of the water bills as business-use.

Tip:  If you are going to claim a disproportionate amount of utilities as deductible business-use, especially if you are claiming a higher amount, be sure that you can substantiate that claim with good records and evidence.  In the example above, Mike keeps records of all of the electricity bills and marks months where he did not use the shop as much so that the difference in usage can be substantiated.

Another indirect expense that has special treatment is homeowner’s insurance.  The IRS only allows the portion of insurance premium that applies to the current year to be deducted in that year.  So, if you make an annual payment for your insurance on October 1^st, then you may deduct ¼ of that premium (3 out of 12 months worth of insurance), multiplied by the business-use percentage, this year and the remainder would be deducted in the following year.  Of course, you could also claim this year the 9 months worth of premium that you were not able to claim the previous year.

Also be aware that the IRS does not allow a deduction for the first phone line into the home.  The cost of basic local service, plus taxes, for the first phone line is considered 100% personal, even if you could prove that it was used 100% for business.  However, the cost of additional services on that phone line, such as long-distance service or voice-mail, can be used as business deductions to the extent that they can be shown to be for business use.

Unrelated expenses are those that have a benefit to the home, but no benefit to the business portion of the home.  If, for example, you run an internet based search-engine optimization business, and you replace your kitchen stove, you would not be able to claim any portion of that expense as a business deduction.

One important item to note is that you usually cannot claim landscape installation or maintenance as a business related expense.  The only exception to this rule is if you see clients, customers or patients in your home.

How much of a particular expense can I deduct?  If it is a directly-related expense, you can deduct all of it.  However, even for direct expenses, if the expense was for an item that falls under the rules of depreciation (ex: furniture or equipment) you must follow the depreciation rules and the deduction will be taken on a different portion of the tax return – not the business use of the home deduction.

If the expense is indirectly related, you will deduct the amount that is proportionate to the amount of space your business uses in the home (see the explanation and example given in the “indirectly related expenses” section above.)

If your business is a daycare, there is one additional rule that you must follow for indirect expenses.  As with all businesses you must multiply the percentage of space used by the expense (i.e. 10% of all utilities.)  Then you must also multiply that number by the percentage of hours used for the business.   

Example:  Mike’s mother, Nancy, runs a daycare in her home ten hours per day, five days per week, fifty weeks per year.  This makes a total of 2,500 hours per year.  There are 8,760 hours in a non-leap year, so the daycare is run 28.54% of the available hours in a year.  If Nancy makes 50% of her house available to the children in the daycare, and her annual electric bill is $1,800, she would be able to deduct $257 of her electric bill as business-use (50% of home used  x  28.54% of the time  x  $1,800  =  $257.)

Tip:  If you run a daycare there are several other special deductions of which you should be aware. Be sure to consult a tax advisor.

Can I claim depreciation on the home?  

Beginning with the first month that you can establish a business-use of the home you may begin to depreciate that portion of the home.  In order to do so, you must first establish a “basis” in the home, or in other words, the value of the home that you can base the depreciation on.

For the purpose of the Business Use deduction, the basis of the home is the lesser of:

• The original cost of the home, plus the cost of improvements, minus any depreciation previously taken,  – OR –
• The fair market value of the home when you started using it for business.

Given the conditions of the housing market, your current home value may be less than what you paid for it.  If this is the case, you must use that smaller value in your depreciation formula.

Tip:   I would recommend getting some third-party valuation of your home at the time that you begin to take this deduction.  An appraisal would obviously be the best, but I think that even a realtor’s evaluation or a website like Zillow.com would be better than nothing.  I don’t know how these later sources would hold up in an audit, but you could at least show that you had reasonable cause for the basis that you showed.

Once you have established the total cost of the home, or its current value (if less), then you must subtract from that number the value of the land that the house is on.  This is because land cannot be depreciated.  The best source for the land value is your real estate tax bill.  It will usually show the value that the county assessor has given the land versus the buildings.  After you have subtracted this amount you have arrived at the “basis” of the home.

The next step is to multiply the basis of the home by the percentage of the home used for business purposes. This will give you the net depreciable basis of the home for business purposes.

Example:  Mike’s home is 2,300 square feet, and the workshop is 200 square feet, making a total of 2,500 square feet for business-use calculations. This means that 8% of his home (200 / 2,500 = 8%) is qualified for business-use deductions.

Mike purchased his home for $200,000 and has made $40,000 in improvements, for a total cost of $240,000.  His home was recently appraised at $300,000 when he refinanced.  The cost of $240,000 is lower than the appraisal, so the cost will be used as the basis.

The depreciable basis for Mike’s home is $19,200 (8% x $240,000 = $19,200.) This is the number that all depreciation for the business use of his home will be based on.

As long as you began using your home for business after 1993, your home office will be depreciated over 39 years. (If you began using your home for business purposes during or before 1993 there are other rules for you to consider that I will not cover here.  See a tax advisor for assistance.)  That would translate into being able to depreciate 2.564% of the depreciable basis each year.

The exception to this standard annual depreciation rate would be in the first year that depreciation is claimed (or in any year that the business-use is not for a full year.)  In that year a deduction can only be claimed for the portion of the year that the property was used for business.  See the table below to know what percentage should be used for depreciation in the first year of business use.

Example:  The first year that Mike used his workshop for business he began using it in September. In that year he would be able to claim $144 in depreciation expense ($19,200 depreciable basis x 0.749% from the table = $144.)  In all other years he would claim $492 ($19,200 x 2.564% = $492) until the basis is fully depreciated.

First-year Allowable Depreciation of the Home

Month	%	Month	%	Month	%
January	2.461	May	1.605	September	0.749
February	2.247	June	1.391	October	0.535
March	2.033	July	1.177	November	0.321
April	1.819	August	0.963	December	0.107

 

How do I claim the deduction on my tax return?

For business owners, the principal form used to calculate and report expenses related to the business use of the home is Form 8829. This is the form where most of the number crunching happens, and which shows the IRS how you arrived at the dollar amount of the deduction you are claiming. Once the total amount is determined, this number then flows to the Schedule where the other business income and expenses are reported. For the self-employed that would be Schedule C, and it would be Schedule E for the Partner, S-Corp owner, or rental owner.

For employees, the expenses are reported on Form 2106, which then flow through to Schedule A and are subject to the 2%-of-AGI minimum of miscellaneous deductions as unreimbursed employee expenses. The employee (and farmer) is not required to use Form 8829 to compute the deductible expenses. The IRS provides a worksheet to help calculate the deductible amounts, which should be retained by the taxpayer with other tax records.

Tip:   Employees who claim a business use of the home should not put any mortgage interest or real estate tax as part of that deduction. Rather, those expenses should be reported completely as person expenses on Schedule A. This will bring a greater benefit because they are not subject to the 2% floor.

A Warning:

If you have determined that you are eligible to claim a deduction for the business use of your home, don’t assume blindly that because you can, you should. There are some significant potential downsides to taking that deduction. Be sure to read Part 4  before making your decision to deduct those expenses.