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Explaining the IRS Home Office Deduction in Plain Language

written by: Alice Rovney•edited by: Jean Scheid•updated: 5/19/2011

Are you paying more taxes to the IRS than you should? If you work from home and aren't claiming the home office deduction properly than you probably are. Of course, there is always the possibility that you're improperly deducting too much in home office expenses and that could result in penalties.

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    Yes We Can Deduct Home Office Expenses!

    IRS home office deduction 

    Yes, there are advantages to working from home not the least of which is the ability to deduct expenses on your tax return. Be warned though, the IRS home office deduction has specific criteria and parameters. Learning these rules and parameters will help you to prepare your tax return more accurately, or at least provide the information to your preparer so they can. Not knowing the rules will cost you money by way of unclaimed deductions or penalties for deducting the wrong amounts. So read on friend. Knowledge is power!

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    The Basics

    Having a home office allows you to deduct a portion of some household expenses such as mortgage, utilities, rent and insurance. That's part of what makes working from home so neat. In order to take the home office deduction, your first step is to determine if you meet the following conditions:

    First, your home office must be used exclusively and regularly for business. This means that you have designated an area in a room specifically for business purposes and that area is not used for personal purposes at all. Typically, if someone walks into your home office space they should be able to tell right away that it is strictly used for business purposes. That makes it clearly definable. This rule also means that you must use your home office to conduct regular business on an ongoing basis. If you use the space only occasionally than it does not qualify.

    Second, you must meet one of the following criteria:

    1. Your home office is your main place of business, or
    2. Your home office is used to meet with clients, patients or customers on a regular basis and such meetings are a normal part of conducting your business, or
    3. Your home office is a detached structure from your home and used for your business.
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    Allowable Expenses

    Expenses usually come in two types: direct and indirect. Direct expenses are related to your home office and nothing else. So, for example, if you have a designated room as your home office and you decide to replace the flooring in that room then the cost to replace the flooring is a direct expense. However, costs such as utilities, mortgage, rent, real estate taxes, insurance, repairs and so on, are indirect expenses. They're indirect home office expenses because because they affect your entire home, not just the office portion. In order to deduct these expenses you make a simple calculation.

    1. Learn what the square footage of your home is.
    2. Measure your office space to determine its square footage.
    3. Divide the square footage of your office space by the entire home's square footage to come up with a percent.
    4. Multiple your expense by that percent.

    To learn more about terms such as direct and indirect expenses mosey on over to Rupen Sharma's article Example of Costs in Project Management.

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    Example of Square Footage Calculation

    Calculating Taxes for Home Office To help you utilize the IRS home office deduction when it comes to figuring your square footage, use this example:

    • Square footage of home: 2,500
    • Square footage of home office: 250
    • Calculation: 250 / 2,500 = 10%
    • Electric Bill (Utility) is $175.00.
    • Your home office deduction = 175 * .1 (10%) = $17.50.
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    Special Circumstances

    Day care facilities and storage areas are an exception to the IRS exclusivity rule. This means that day care facilities can use spaces, such as the living room, for personal and business purposes. However, you must have a license that designates you as a day care provider. Examples of day care facilities include:

    • Caring for children
    • Caring for the elderly
    • Caring for persons who are mentally or physically unable to care for themselves.

    The method on how to allocate indirect expenses is different for day care facilities. There are two main methods and both have to do with time:

    1. Divide the number of hours that you are in business for the week by the total number of hours available in a week (24 *7 = 168). This is the percent you will use to allocate costs. For example, if you operate your day care 40 hours per week then your percent is 24% (40/168).
    2. Divide the number of hours you operate your business in one year by the total number of hours in a tax year (365 * 24 = 8,760). So if your day care facility operates for 2,080 hours a year (40 hours per week * 52 weeks) then your percent is 24%.

    Sometimes your home is used to store inventory such as goods you plan to sell or product samples. In this case, you can include the amount of space to store your inventory in your IRS home office deduction, even if part of that space is used for personal purposes. Think about areas like a garage for this. In the garage example, you can only include that portion of the garage used for storing inventory. For more great reading on how to run a profitable daycare, give Arun Kumar's article How Profitable is Running a Day Care Business a read.

    Wasn't that easy?

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    Sources:

    Weltman, Barbara. Small Business Taxes 2010. John Wiley & Sons, inc.

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