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Understanding the Home Office Tax Deduction for Small-Business Owners

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    Technological advances are giving entrepreneurs a leg up on the competition. One significant advantage is the ability to work effectively out of a home office.

    Nearly 70 percent  of small businesses start off in a home office. There are many reasons to begin at home. For starters, it is an effective way to keep business expenses down.

    In addition, you can write off some business expenses as home office tax deductions. Read on to learn all about the simplified home office deduction. Explore a comprehensive guide on deducting home office expenses, including benefits, qualifications, and more.

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    Standard Method​ of Home Office Deduction

    In the past, small business owners could only use the standard method for deducting home office expenses. However, this method was considered too cumbersome and complicated for many tax filers.
    The standard method requires business owners to account for all home office expenses. Next, the tax filer needs to calculate what percentage of their home is dedicated to the business. This determination is subjective and often leads to confusion.
    You can multiply this rate by all indirect costs that are incurred. These costs include things like mortgage interest and depreciation.
    Direct costs can be deducted in full. There are many costs incurred during business operations. If you paint the home office, this is considered a direct cost of business. Other items, like home office supplies and business phones, are also direct costs.

    Itemized Tax Deductions

    Simplified Home Office Tax Deduction​

    Starting on January 1st, 2013, the Internal Revenue Service (IRS) authorized the use of a simplified home office deduction. This method is significantly easier than the standard calculation.
    The first input to the equation is a prescribed rate set by the IRS. The second input is the square footage of your home. The benefit to the tax filer is that they do not need to calculate actual expenses.
    The rate set by the IRS is $5 per square foot. You can use this rate for up to 300 square feet. This means the maximum deduction for the simplified method is $1500.

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    Just because you work at home does not mean you are automatically eligible for the deduction. There are a few different factors that the IRS reviews for eligibility.

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    Principal Place of Business

    First off, the home office must be your principal place of business. This means that you process sales or hold in-person meetings with clients in the home.
    You cannot frequently operate in a commercial office and claim the deduction. Also, it is not designed for businesses that sporadically telework from home.

    Business Tax Home Office Tax Deduction

    Regular and Exclusive Use​

    The second criteria is the regular and exclusive use of the home office. If you routinely use another setting for work, you cannot properly claim the deduction.
    Also, there are some rules that establish whether a room is used exclusively for business. This means that you have a dedicated space, such as a separate room, for business. You cannot simply place a desk in your bedroom and claim the deduction.
    A partition or divider may be acceptable to establish a home office. The intent is to demonstrate to the IRS that you are not mixing personal activities with business.
    The IRS is strict about the exclusive use rule. For instance, you will not qualify if the room doubles as a playroom for your children.
    This is not to say that you can never conduct personal matters in the room. Employees across the nation take phone calls and have personal conversations at work. To the IRS, this level of personal activity is acceptable in a home office.

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    Business Qualifications for the Home Office Tax Deduction​

    Your business needs to meet specific criteria, as well. Of course, you need to generate revenue. However, a steady stream of inflow is not sufficient enough.
    The business needs to earn a profit. Obviously, your business is not going to pay taxes without an income source.
    Another factor to consider is that managing your investments does not count as a business. This goes for real estate investors as well. Real estate investors can get the home office deduction, but only when their work is classified as property management.

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    Every business is susceptible to an IRS audit. This is where the IRS validates that your company’s reported income and expenses are accurate.
    Therefore, you should keep detailed records of all business expenses. If you plan to claim the home office deduction, maintain receipts for all direct and indirect expenses incurred. With detailed receipts, you can be prepared to back up your claims against an IRS audit.

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    Other Considerations Regarding Home Office Tax Deductions

    The information contained within this article is not intended to scare you. The truth is that IRS audits are increasingly rare. While following the IRS guidelines to the maximum extent, you should confidently use the home office deduction.

    Another thing to consider is claiming the home office deduction while simultaneously selling your residence. This scenario can create complications with the capital gains tax.

    According to IRS publication 523, you do not have to pay capital gains on your home sale for profit up to $250,000. This figure increases to $500,000 if you are married and filing jointly.

    Depreciation is the link between the home office deduction and capital gains tax. First, you are required to claim depreciation if you use the standard method and list all actual expenses. When you sell your home, depreciation is subject to capital gains tax.

    Remember the percentage of your home that is considered home office? Consider that you will deduct depreciation on this percentage.

    Envision a scenario in which 10 percent of your residence is used as a home office. When you sell, this 10 percent is exposed to capital gains tax.

    How To Prepare Your Home Office For The Irs

    A Recap of the Home Office Deduction

    A growing number of Americans are running businesses out of their homes. It is a great way to improve quality of life and keep operating expenses down.

    Better yet, the IRS allows you to deduct expenses incurred. Following the simplified method, this yields up to a $1,500 deduction. If you need help using the simplified home office deduction, contact us today to set up an appointment.

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