According to the Small Business Administration, about 50 percent of all U.S. businesses are home-based. About 60 percent of businesses without employees — that is, Indys — use the owner’s home address, as well.
If you’re gearing up for the transition to full-time freelancing or sole proprietorship, there’s a good chance you’ll start out of a home office. Your choice will significantly reduce your overhead costs — no office rent, less mileage on your car — and may save you a bundle at tax time, too, thanks to the IRS’s home office deduction.
Defining a Home-Based Business
The SBA defines a home-based business as one “operated primarily out of one’s home,” meaning a home-based Indy may work part-time out of coworking space, virtual office, or coffee shop.
Most home-based business owners, including Indys, maintain home offices. An Indy who engages in small-scale production activity may call her workspaces something other than an “office”: “workshop” or “studio,” perhaps. The IRS doesn’t really care what you call your home workspace, as long as it’s “a part of your home [used] regularly and exclusively for business purposes.” The IRS prefers the catchall phrase, “business use of your home.”
The eligible part of your home must be your principal place of business or “a place where you meet clients or customers in the normal course of business.” This can be in a room in the main unit or structure, or in part or all of an auxiliary structure on the property (for instance, a backyard studio or converted mother-in-law suite). Both homeowners and renters may deduct qualifying business-use-of-home expenses on their federal and (if applicable) state tax returns.
Common Business-Use-of-Home Expenses
Business-use-of-home expenses fall into two main buckets:
- Indirect expenses, which apply to the non-business portion of the property as well
- Direct (office only) expenses, which apply only to the business portion
Examples of indirect expenses
Most recurring and one-off household expenses live in this bucket:
- Housing payments (rent, mortgage principal and interest)
- Real estate property taxes
- Homeowners’ or renters’ insurance
- Homeowners’ association dues
- Depreciation (a complex calculation that allows homeowners to figure wear and tear on their home’s structure)
- Gas and electric utilities
- Water utilities
- Trash and recycling removal
- Telecommunications (Internet and cable)
- Certain home services, such as security systems and professional house cleaning
- Home maintenance and repairs, such as a boiler tune-up or roof replacement
Examples of direct expenses
This bucket includes localized outlays with no benefit to non-business portions of the home:
- Maintenance, such as a fresh coat of paint or new outlet covers
- Repairs and improvements, such as new or replacement wiring and dedicated telecommunications service (such as a landline used exclusively for business)
- Targeted services, such as professional carpet cleaning in the office only
- Qualifying third-party labor on the above (generally, reasonable wages or retainers paid to hired helpers, but not to yourself)
- Utilities and other ongoing expenses for a standalone structure used wholly and exclusively for business, such as a backyard studio with separate gas, electric, and water hookups
Understanding these buckets is only the first step. The rubber really hits the road during tax season, when you get around to computing and tallying your business-use-of-home expenses.
In the meantime, keep all household expense receipts in a safe place, even if you’re not sure they have any bearing on your home office deduction. Try a simple filing drawer with folders organized by expense type (utilities, repairs, housing payments), or a digital receipt organizer like Shoeboxed.
Computing and Deducting Business-Use-of-Home Expenses
Now, for the fun part: computing, tallying, and deducting your business-use-of-home expenses.
Computing indirect business-use-of-home expenses
Divide your home office’s square footage by the total livable square footage of your home — not including the attic, unfinished basement, crawlspace. Multiply this percentage by each indirect expense to find the business use portion of that expense. For indirect expenses paid monthly, like utility bills and housing payments, sum payments for the entire tax year first.
To save time, you can sum all indirect expenses and multiply once by your business use percentage.
Here’s a simplified example. Your home is 2,000 square feet, and the converted bedroom you’re using as your principal place of business is 150 square feet.
150/2,000 = 0.075, or 7.5%.
The sum of all your indirect expenses — utilities, housing payments, home repairs, and so on — is $20,000.
0.075 * 20,000 = 1,500.
The deductible portion of your home’s indirect business-use-of-home expenses is $1,500. You can deduct this amount from your profit on Schedule C or Form 8829, depending how you file.
Computing direct business-use-of-home expenses
Qualifying direct home office expenses are fully deductible on Schedule C or Form 8829. That $150 you spent on painting supplies reduces your net profit by $150. Ditto for that $99-a-month business phone-and-Internet plan. There’s no need to multiply by square footage or factor.
If you use a DIY tax prep program, the system should clearly delineate between direct and indirect expenses.
Computing your home office deduction with the simplified option
Not a fan of recordkeeping or paperwork? The IRS gives you an out: the simplified option for home office deduction.
Like the standard personal deduction, the simplified option lets you take a guaranteed home office deduction and skip the hassle of keeping receipts. Simply multiply your home office’s total square footage by $5 to find your simplified home office deduction. Since the maximum allowable simplified deduction is $1,500 (assuming a 300-square-foot office), this method is only appropriate for low-cost home offices. In a spendier neighborhood, the home office portion of your annual housing outlay alone may exceed $1,500.
When in doubt...
The IRS has far more detail about the home office deduction in Publication 587, Business Use of Your Home. A quick glance at Pub 587 reveals just how dicey this topic can get, so it’s imperative that you review it carefully before filing your taxes next year — and consult a tax professional with any questions or concerns, no matter how basic.