The 2020 Guide to Home Office Tax Deductions
with insights from Melissa Groves, Head of Tax Planning at Smart.
There’s a light at the end of every tunnel, and for some small business owners, tax season can provide a sizeable opportunity to save money.
With the increasing number of people working from home over the past few years, the home office tax deduction is a feasible way to maximize deductions, if appropriately handled. Here’s how small businesses can take advantage of the time spent running operations from home.
Who is eligible for 2020 home office tax deductions?
If you are a small business owner or self-employed and working from home, you could be eligible to benefit from the 2020 home office deductions under specific requirements. However, home office deductions currently do not apply to W-2 employees, unless you have a side business which would fall under the self-employed rule. Up until the 2017 Tax Cuts and Jobs Act (TCJA), the deduction previously extended to nearly everyone working at some remote capacity with a less prescriptive set of requirements to comply with.
Understanding tax credits vs. deductions
Tax credits and deductions are likely (if only) the most exciting step in filing taxes for business owners. Both exist to reduce your tax bill, however, in very different ways. This guide covers how to use deductions, but it’s essential to know how they differ.
- Tax credits are a dollar-for-dollar reduction of your tax liability that directly reduces the amount of taxes you owe, giving you. Some tax credits are refundable such as the Lifetime Learning Credit, but many include income restrictions.
- Tax deductions are a dollar amount the IRS allows you to subtract from your adjusted gross income (AGI), making your taxable income lower. This means you’ll have a lower tax bill in the end.
Tax credits are more beneficial to reducing your tax bill. Both require meeting specific qualifications based on your filing status, current life events, and the amount of your income taxable. A tax advisor can help clarify if you meet the IRS criteria to qualify for both tax credits and deductions.
Requirements for home office tax deductions
The 2020 home office deductions apply to both homeowners and renters, regardless of what type of home you live in (excluding hotels or temporary lodging.) Additionally, freestanding structures such as garages or studio spaces qualify as long as it meets one of the following requirements.
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Regular & exclusive use requires that the area you’re operating in for business must be used exclusively for business. Translation: if your space doubles as a guest bedroom, it doesn’t fit the requirement. The IRS makes exceptions for licensed daycare spaces or storage for inventory.
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Principal place of business requires that part of your home be used as your principal place of business. This doesn’t require your home to be the space where you meet clients. However, you must use it exclusively for “administrative or management activities.” According to the IRS, you must not have any other location where you also conduct a substantial amount of “administrative or management activities.”
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Separate spaces or separately identifiable spaces are eligible to qualify for the home office deduction. This means it doesn’t have to be a full room (or divided) but rather a dedicated workspace of some kind. For example, creating a workspace on the right side of your living area could qualify as long as it’s solely used as a workspace.
Expenses That Qualify for a Deduction
Another satisfying component of home office reduction is taking advantage of the other expenses you can package in along the way. After determining the space you’re eligible to use (more on this below), you can include costs on home depreciation, property taxes, homeowner’s insurance, and business percentage of deductible mortgage interest.
Up to 15% of your annual utility bill is deductible only if your office space occupied 15% of your home.
How to determine your deductions
In researching home office deductions, you may have come across two options for calculating expenses: the standard method and the simplified method. This decision largely depends on what would result in the larger taxable deduction.
- The simplified method allows you to opt for an easier way of determining your deductions by calculating the square footage of your office space by a prescribed rate of $5 for up to a maximum of $1,500 for a 300-square-foot space.
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The standard method allows you to deduct the full cost of direct expenses to the office space. In contrast, indirect expenses are only accounted for based on the percentage of your home used for business. This method is more sophisticated but could net a higher deduction depending on your business or circumstances.
In summation, the simplified method can work well for single-room offices and small operations. The actual-expenses method might work better if the business makes up a large part of the home.
The varying rules around home office deductions can be nuanced, but worth the effort in conserving your cost in a particularly changing climate. Keep detailed records of expenses, repairs, or purchases to prepare for any potential audits. If you’re a business owner or self-employed individual working from home, we would advise to speak with your tax advisor before claiming any tax credit or deduction as this is not an all-encompassing list of rules around home office deductions. If you do not have a tax advisor, feel free to book an appointment with us today.