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What to Know About Changes to the Home-Office Deduction

There are changes to how you can deduct the home space you use for your business. Here's what you need to know.
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More than 52 percent of all businesses in the U.S. now operate from home. So it’s no wonder that many business owners use a portion of their residence to conduct business and, like office rent in commercial space, want to deduct their costs.

They can, but the way in which they figure the deduction is brand new for 2013 return.

What’s new
Until now, you could only deduct the actual expenses related to the home office. Thus, if you used 10 percent of your home for business, then 10 percent of your rent (or mortgage, interest, real-estate taxes, and a depreciation allowance if you owned the home), utilities, security systems, insurance, and other costs would make up your home-office deduction. You were also allowed to add the full amount of any direct costs, such as painting the spare bedroom you use as a home office.

Now you have a choice: Figure your actual costs as in the past, or take a simplified deduction, which is $5 per square foot up to 300 square feet of space used for business.

What has not changed
While you can simplify your record-keeping (you don’t need to keep all your utility bills if you’re using the simplified deduction), you still have to meet the two basic home-office deduction rules in order to qualify for a write-off:

: The office in your home must be your principal place of business. This means your home space must be any of the following situations:

 - Your principal place of business (usually where you earn your money). If you work outside the home at customer/client/patient locations, you satisfy this test if you use your home office for substantial administrative activities (keeping your books, ordering supplies, scheduling appointments, and doing job estimates).

- The place to meet or deal with clients/customers/patients in the ordinary course of business. Thus, if you have a commercial office but have clients come to your home office to review plans, sign contracts, or discuss projects, you meet this test. However, merely making business calls in the evening from your home office is not enough.

- A separate structure used for business. Thus, if you use a freestanding garage as a studio, you can treat the space as a home office even if you have another studio elsewhere.

: You must use the home office regularly and exclusively for business. You can’t use the kitchen table as a home office in most cases because you use it for meals (not business).

Which choice is better?
You’ll have to decide for yourself, based on your situation. You can make your decision each year, using the actual method in one year and the simplified method the next. Here are some factors to help you:

- If your home office space is larger than 300 square feet, you may be cheating yourself if you don’t figure your actual costs.

- If you lack records for certain expenses, use the simplified method.

- If you know your actual expenses are more than the maximum allowed with the simplified method, which is $1,500 ($5/sq. ft. x 300 sq. ft.).

- If your business isn’t profitable for the year, use the actual method. You won’t be able to take the home-office deduction (because of a gross income limit), but you will be able to carry over the unused deduction and apply it in future years when you are profitable. There is no carryover for the simplified deduction.

- If you use more than one home office in the year (e.g., you move to a new home), you can only use the simplified method for one office. Thus, you’d be better off using the actual method, which can be used for each office.

- If you have sizable home-related itemized deductions for mortgage interest and real estate taxes, you must allocate them for the actual method; no allocation is required for the simplified method. Thus, you can take the simplified method while still itemizing all of these home-related deductions.

Many small business owners working from home do not take any home-office deduction because they fear it will be an audit red flag, attracting IRS scrutiny. The IRS has never released statistics showing this belief to be true or false. However, the fact that now more than half of all small businesses operate from home and that the IRS has created a new simplified deduction would belie the audit trigger belief. Bottom line: If you’re eligible for the deduction, take it!