A Home Office in Your Home
Let's start with the most common situation for our clients: you own a home and use part of it for a home office or studio. You may have done this in the past in a rented apartment or home, but things will be a bit different now that you own the place where you live.
You can definitely still deduct your home office expenses for a qualified home office (check out our article on how to figure out if you've got a home office). And remember, generally this only comes up for folks who are self-employed (i.e. not people who earn all their money on W-2 jobs). Make sure you've taken a second to figure out how big your home office is. And then, these are the other numbers we'll need to know about your home office:
- We'll need to know all the numbers outlined in this article: "I Own a Home, What Things Do I Need To Keep Track Of?"
- We'll also need to know any of the costs associated with home improvements, including any improvements or repairs that only impacted your home office
- And lastly, a few additional things for the home office:
- Total cost of utilities (water, heat, electric, etc.)
- Homeowner's insurance
- Monthly co-op or condo maintenance fees
- The costs of any furniture you bought exclusively for the home office
Note on Method
When it comes to your home office, we actually have two options for calculating the business deduction related to your home office: the actual costs (related to everything listed above), or a simplified method (which uses a standard IRS rate and usually results in a smaller deduction for our clients). Why would anyone want to take a smaller deduction? It gets a little complicated, but essentially it boils down to this, when you sell your house, if you take actual expenses, you have to add the total amount you've deducted across every year and then subtract that from the basis (how much you paid) for your home (since you already got a tax benefit for it). We get into this more in the section below, but the upshot of it all is that you're either gonna get a tax benefit now or a tax benefit later. In your conversation with your advisor we can help you think through which option makes the most sense for you.
Renting Part of Your Home
While renting out part of your home is a bit different than having a home office (and some of our clients have both things), the reality is that they're both business uses of your home. And so we
In terms of the numbers we need, it's actually pretty similar to the list for a home office:
- We'll need to know all the numbers outlined in this article: "I Own a Home, What Things Do I Need To Keep Track Of?"
- We'll also need to know any of the costs associated with home improvements, including any improvements or repairs that only impacted your rental space
- And then these things (for the whole house, unless you have separate meters/bills for the rented part of the home)
- Total cost of utilities (water, heat, electric, etc.)
- Homeowner's insurance
- Monthly co-op or condo maintenance fees
- The costs of any furniture you bought exclusively for the rental
- The cost of cleaning/maintaining the rental (if you pay a cleaning service, for instance, not your own time spent cleaning)
- Any money you spend advertising the rental
- Any fees you pay to a company or person to manage the rental
- Any supplies/materials purchased only for the rental (sheets, towels, etc.)
Things To Consider About Your Home Office or Rental
Once you start using a portion of your primary residence as a home office or a rental, that portion becomes business property, and you are required to depreciate it. The only exception to this is for folks who choose to use the simplified method for their home office (see note above). Also note: Only the building itself is depreciable, the land cost is not depreciable (that's why we ask you to keep a record of the land cost). For example, if you bought a home for $120,000 and the land is valued at $20,000, you will use $100,000 as your basis for depreciation.
Think of depreciation like taking a business expense for wear and tear on your home. You're paying to maintain the home and a portion of it is being used for business, and so we get to deduct a percentage of what you're paying for the home to account for business-related wear and tear.
We'll help you figure out the right percentages and set it up on your taxes, but the important thing to understand is that whatever depreciation we take, whether it's for your home office or your rental (or both), we're going to have to factor that in when you sell the home.
What does that mean? When you deduct a portion of your home cost as business expense you're getting a tax benefit (i.e. your reducing your profits). When you sell the home, the government wants to make sure you're not benefitting twice from that same amount, so we have to subtract it from the basis for your home (the amount you paid for the home when you bought it).
- Here's an example: Let's say you buy your home for $300,000 and $50,000 is the land value. You've got a small home office and you also rent out a spare bedroom on AirBnb, and together they take up about 25% of your home. Because of the rules of deprecation (we have to spread these costs out for 39 years), you're able to take about $1,600 each year. You live in the house for 10 years and then sell it. Let's say you sell it for $500,000. We'll take that $16,000 (10 x $1,600) and need to subtract it from the original $300,000 you paid for the house in order to figure out how much profit you made: $300,000 - $16,000 = $284,000. So your profit on the $500,000 sale is $216,000.
The good news is that if you are single and you owned and lived in the house for at least two of the five years before the sale, then up to $250,000 of profit is tax-free. If you're married and file a joint return, up to $500,000 of the profit is tax-free. So in that example, you won't owe any taxes on that profit since you lived there for ten years. But all of this is still useful to keep in the back of your mind (or in a dark drawer in a dark corner of the basement that you never want to think about again...).
Make sure to also read our article on capital improvements, which generally get added to your purchase price.
Got questions, concerns, curiosity about which methodology you should use for your home office? Just sent an email over to info@brasstaxes.com and we can set up a consultation.