Friday, August 4, 2006

Is The Home Office Deduction Worth It?

Ron from Jacksonville, TX asks:
I am considering using $50,000 worth of a new home as a home office for 20 years. My personal and business tax rates are identical. I'll ignore expenses that are business deductible in both cases.

With a home office I estimate I can write off $25,000 in depreciation, another $1,000 in home repair, and $4,000 in general utilities that are not business deductible (heating, water...). This means a savings of $39,000 times my tax rate or about $10,800.

Assuming I sell this house after the 20 years, for 150% of the original price then I will be facing a capital gain of ($50,000 * 1.5 – 25,000) of $50,000 in capital gainswith a tax consequence of $10,000. A net gain of $800 for 20 years of record keeping and form filing.

Of course the result could be better or worse depending on the appreciation. I think the home office deduction is a loser. What am I missing?

My answer: I believe that establishing a home office can provide significant tax benefits for the sole proprietor. Since you asked about it, you obviously thought so as well and your gut was right.

The home office deduction is not an easy calculation and is best left up to a tax professional. You haven't supplied all the necessary information for me to tell you
exactly what you would be able to deduct (or if you are actually allowed to claim a home office deduction), but I will attempt to explain in general how the home office deduction might work.

The first step is to figure out how much space you will be using in your home exclusively for businesses purposes.

  • Office area (desk, printer stand, file cabinets, etc.) is 15' X 15' or 225 sq. feet
  • Office closet (storage of office supplies, more filing cabinets, etc.) is 4' X 4' or 16 sq. feet
  • Garage (one car slot is 10' X 20', car is used 60% for business) is 120 sq. feet (200 X 60%)
total business area of your home is 361 sq. feet (225 + 16 + 120).

Assuming that your home is 2,000 sq. feet plus you have a two car garage (800 sq. feet), then your total home square footage is 2,800 and your business use percentage is 12.9% (361/2800).

Assuming the cost of your home is $125,000 and your land is valued at $25,000 then your assumed basis would be $100,000. Your business use portion of your basis would be $12,900 (100,000 X 12.9%). You can deduct this $12,900 over 39 years, in the form of depreciation, which amounts to $331 a year.

Assuming your utilities (electric, water, trash, etc.) are $3,000 per year you can deduct $387 (3,000 X 12.9%).

If you make any repairs (replace the broken overhead light) or have any maintenance costs (carpet cleaning) specifically for your home office they are fully deductible. If you make repairs or have an improvement for the whole house then you can only deduct the business percentage. I will assume you have no repairs.

Assuming that your property taxes are $5,000 you can deduct $645 as a home office deduction and $4,355 as an itemized deduction.

Assuming your mortgage interest is $7,000 you can deduct $903 as a home office deduction and $6,097 as an itemized deduction.

Insurance is also deductible. All business insurance is completely deductible. The business portion of your homeowners insurance is deductible as part of the home office deduction. We'll assume that is $2,000 X 12.9% = $258.

Let's take a look at this in a table:

Previously Non-deductible Expenses in first full yearHome Office Deductions for first full yearPotential 20 year savings, excluding increases in utility costs, insurance & property taxes
Property Taxes
Mortgage Interest
Homeowners Ins.$258$258$5,160
Total additional deductions$976$2,524$50,480

Potential Self-Employment Taxes Saved (15.3%) on additional deductions$149$386$7,723
Potential Federal Taxes Saved at 35% on additional deductions less ½ self-employment taxes$315

Potential Recapture of Depreciation 25%($83)

Potential Total Estimated Tax Savings


As you can see, if you have a qualified home office you can deduct expenses that you are already paying (since you're living in house). These expenses reduce the profit on your business. A lower profit on your business reduces the amount of Self-Employment and Federal Taxes that you pay with respect to that business. In the above example you would save $386/year in self-employment taxes and $342/year in Federal taxes for a total yearly tax savings of $701.

If you were to subsequently sell your house, any gain on the sale of your property up to the amount of depreciation you have taken will be taxable at your regular tax rate up to a maximum long-term capital rate of 25% as long as you have owned the property for at least one year. otherwise it's taxed at your regular income tax rates. In this example that would be a potential recapture of
$83/year in taxes.

The potential tax savings indicated above exclude increases in utility costs, homeowners insurance and property taxes. It also excludes the gain you receive in benefiting from the depreciation deduction now and not paying the tax on it
until you sell – in this case 20 years later. This has to do with the time value of money and is beyond the scope of this article.

Having a true home office is a great way to keep your overhead low since you are already paying for the space. If you don't use your home office you will have to buy or rent space elsewhere which is a cost you aren't currently incurring and didn't include above.

Could the home office deduction be a red flag? Possibly, however, considering the fairly low percentage of all returns that are audited, you probably don't have reason for concern unless you claim an outlandishly high deduction.

Whenever the issue of "red flags" come up with my clients, I always point out that if you are legitimately entitled to a deduction, the fear of an audit should not be an issue. It is your legal right to take advantage of every possible deduction that the Internal Revenue Code makes available to you. If you keep good records, and file an accurate return, you have nothing to worry about.

1 comment:

Britt said...

Wow, Gina, you are a wealth of information. Thanks for breaking this down and making it so easily understood.