How the home office deduction works for freelancers

Who qualifies for the home office deduction?

Most home costs are personal and not deductible. You can deduct the business part only if a specific area of your home passes these tests.

Exclusive use

The area must be used only for your business. A spare room that is your office all day and a guest room on weekends fails. The space does not need a permanent partition, but it must be a separately identifiable area that you don't use for personal things. There are narrow exceptions for storing inventory or product samples and for daycare.

Regular use

You must use the area for business on a regular basis. Incidental or occasional use doesn't count.

Principal place of business

Your home office qualifies as your principal place of business if you use it exclusively and regularly for administrative or management tasks, such as billing, scheduling and bookkeeping, and you have no other fixed location where you do substantial administrative or management work. Doing substantial client work at a fixed location outside your home does not by itself disqualify you.

You can also qualify if you regularly meet clients in the space, or if it is a separate structure, such as a detached studio, used exclusively and regularly for the business.

Method 1: the simplified method

1. Measure the office in square feet. Only up to 300 square feet count.
2. Multiply by $5. The most you can deduct is 300 × $5 = $1,500.
3. Apply the income limit. The deduction can't exceed the gross income from the business use of your home minus your other business expenses. Any excess is lost, not carried over.

With the simplified method there is no depreciation deduction for the home and nothing to recapture later. If you own your home, you claim mortgage interest and real estate taxes on Schedule A as usual if you itemize. You can't also deduct actual home expenses such as rent, utilities or insurance for that office.

Method 2: the regular method (Form 8829)

1. Find your business percentage. Divide the office area by the total area of your home. Any reasonable method works; square footage is the most common.
2. List your home expenses. Direct expenses that benefit only the office, such as painting it, are deductible in full. Indirect expenses for the whole home, such as rent, utilities, insurance, repairs, mortgage interest and real estate taxes, are deductible at your business percentage.
3. Add depreciation if you own. Homeowners depreciate the business part of the home (not the land) as nonresidential real property, straight line over 39 years.
4. Apply the income limit. Expenses that would not be deductible without the office, such as utilities, insurance and depreciation, are limited to the gross income from the business use of your home minus your other business expenses. Unused amounts carry forward to the next year you use the regular method.

Depreciation recapture when you sell

If you sell a home you used for business, you generally can't exclude the part of your gain equal to the depreciation you were allowed after May 6, 1997, even if you otherwise qualify to exclude gain on the sale. This applies to depreciation you could have claimed, even if you didn't claim it. Renters don't face this issue.

Worked example: a renter, both ways

You rent a 1,000-square-foot apartment and use a 200-square-foot room only as your office. Rent is $2,000 a month, utilities are $2,400 a year and renters insurance is $240 a year. Your business has plenty of income to cover the deduction.

Here the regular method gives a $4,328.00 larger deduction. Because the deduction reduces Schedule C net profit, it lowers self-employment tax as well as income tax. The simplified method needs less record keeping, which can matter more when your rent is low or your office is small.

When the income limit applies

Now say the business that uses this office has $30,000 of gross income and $26,000 of other business expenses. The limit is $30,000 − $26,000 = $4,000. Under the regular method you deduct $4,000.00 this year and carry over the remaining $1,328.00. Under the simplified method, the $1,000.00 fits under the limit and is deducted in full.

Choosing a method

• You can switch each year. You choose by using the method on your timely filed original return. You can't change methods for a year after you file.
• Switching back has a catch for owners. If you use the simplified method and later return to the regular method, you figure depreciation with the IRS optional depreciation tables.
• One home only. If you moved during the year, you can use the simplified method for only one of the homes.

Records to keep

• A floor plan or measurements showing the office and total home area.
• Photos showing the space is set up and used only for work.
• Rent or mortgage statements, utility bills, insurance and repair receipts if you use the regular method.
• For owners, the home's cost basis, improvements and the date you started using the office.

How it fits with your other numbers

A home office that is your principal place of business can also make trips from home to clients deductible. See the business mileage deduction. To see what a lower net profit does to your tax, run it through the self-employment tax calculator and update your payments with the quarterly estimated tax calculator. The freelance rate calculator can include workspace costs in your minimum rate.

If you own your home, share it with another business, or plan to sell soon, a tax professional can help you weigh the larger deduction now against recapture later.