Home Office Deduction: What Are the Risks?

If you meet the requirements to take a home office deduction, it might seem like a no-brainer to take it, right?

Not so fast. While this deduction can certainly provide a lot of value to your bottom line come tax time, it’s not always in your best interest. There are many variables that you need to consider before taking this deduction; You need to ensure you actually qualify for it and understand the different calculation methods. 

The home office deduction can result in major tax savings, depending on the value of your home and the size of your home office. It’s a smart move to decrease your overall tax obligation. However, there are definitely some things to keep in mind while you decide if you will take a home office deduction on your income taxes.

Who Qualifies for the Home Office Deduction? 

When considering the deduction, it matters whether you work for a company or are self-employed. It’s not just as simple as working from home; If you are an employee who works from home, you are not eligible for a home office deduction. COVID-19 sent millions of people across the country back to their homes. Many were confused about whether or not they could take the home office deduction. The short answer is no, employees are not eligible.

However, if you’re an employee of a company and you have a side hustle, you’re also a small business owner! Meaning, you’re eligible for a home office deduction as long as the space you use to conduct work takes place within your home. 

For example, if you’re an eCommerce seller, the space you use to store inventory or create the items you’re selling may qualify for the home office deduction as long as you meet all the other criteria. 

Will You Run a Profit or Loss with Your Home Office Deduction?

There’s another important note to keep in mind when considering the home office deduction: will you run a profit or loss after you factor in the home office deduction? 

If your business ran a loss in the given year, you can take your share of the actual business home office expenses as a carry-forward. Meaning, you can carry the loss forward and take it when you have a profit in a future year. 

For example, if you have a thousand dollars in home office expenses that you couldn't take in Year One because you weren't profitable, you can potentially carry those losses into Year Two when you do become profitable! So it's not lost, it’s just held off until you make a profit.

The Possibility of an IRS Audit

The home office deduction has been in existence for quite some time now — since 1959, to be exact. Throughout the years, many people have developed a fear of the home office deduction due to a supposed increased risk of an IRS audit. 

While taking this deduction far from guarantees your chance of receiving an audit notice, there may be some merit to the belief that it can increase the likelihood of one. This all has to do with the IRS’s fraud detection and prevention system, the Discriminant Inventory Function (DIF).

The DIF groups tax returns by profession and then analyzes anomalies to identify red flags. For example, let’s say you’re an eCommerce seller and you deduct 20% of your income for travel. However, according to the DIF, the average eCommerce seller only deducts 5% of their income for travel. This will flag your return and increase your chances of an audit. 

Similarly, the DIF will take a look at who takes the home office deduction and compare that against others within that industry. If you’re a freelance writer taking the home office deduction. It’s pretty likely that that falls within the norm across the freelance writing industry. However, if you’re a freelance bartender taking the home office deduction and you’re the only freelance bartender doing so, it highly increases the odds that the DIF flags your return. 

Your Deduction Could Change If You Sell Your Home

You also need to think about the long-term possibilities.

Let’s take the example of selling a home. If you’ve been claiming a home office deduction, and then you sell the house where your home office is located, it may very well affect your capital gains taxes. 

Depending on the sale price of your home, how long you’ve been claiming that home office and how you claim it could have a major impact. The capital gains tax exclusion allowed from the sale of your primary residence could be reduced by the amount that you have claimed for depreciation on your home office. 

If you use the simplified home office deduction, this does not apply. The simplified method results in a smaller deduction, but it doesn’t involve expense tracking, so record keeping is easy. The simplified method is limited to 300 square feet, and it’s currently set at $5 per square foot. 

While the simplified method may be much easier to calculate, for the vast majority of taxpayers, the actual method will give you a far larger deduction. After you factor in things like depreciation, mortgage, and real estate taxes, the actual method in the majority of circumstances gives you the largest tax benefit.

It’s true that the IRS recaptures the depreciation you took and then taxes you on that amount when you sell your home. However, they only do this for the depreciation you took; they don't look at any home appreciation.

When they recapture the depreciation amount, the tax rate is typically between 15-20 percent on capital gains. However, when you take a home office deduction, you’re reducing ordinary income instead. Which, generally, you are paying a much higher tax rate than 15-20 percent.

Don’t Just Do Your Taxes, Have a Strategy

The home office deduction is a great way to lower your tax burden — but only if you actually qualify for it. Double-check that you meet the requirements. You should also consider the long-term effects of how the home office deduction could affect you down the road. 

If you want to set up a tax-saving strategy that maximizes your deductions, reach out to 1-800Accountant today. You can speak with one of our experts and start working on your long-term, year-round tax strategy.