Does home office deduction lead to an audit risk?

For most taxpayers, the home office deduction can be complicated. Plenty of people contemplate claiming the deduction since it has a lot of perks. However, a lot of taxpayers fear that the deduction isn’t worth the risk since it could trigger an IRS audit.

Let’s clear the air. The home office tax deduction is a  legitimate business expense that qualifying homeowners and renters should not ignore. Now, in order to qualify for the deduction, the home office must be exclusively and regularly used for the purpose of conducting your business. Also, it should serve as the principal place of business.

Why do people fear taking a legitimate deduction?

The home office tax deduction has a reputation for being an audit red flag though it has been around for quite some time. In 1959, the IRS, labeled all expenses of maintaining a household non-deductible, unless the taxpayer “uses part of the house as his/her place of business”.

However, the Tax Reform Act of 1976 included Section 280A, which allows one to deduct items like utilities, insurance, and depreciation of a home on a pro-rata basis. Since then, about once a decade, there is a notable change in IRS rules and/or Supreme Court decisions that impact how 280A is applied and who qualifies for it.

Due to the complexity of the tax law and the record-keeping hassles of the home office deduction, many taxpayers have been hesitant to claim the deduction.  Also, there is a depreciation recapture provision that can mean higher taxes if you sold your home after taking the home office deduction.

While it was once considered to be a red flag, this is no longer true as long as you keep track of bills and receipts that satisfy IRS requirements. Because of the rapidly increasing demand for home offices, tax officials cannot possibly audit all tax returns containing the home office deduction.

In other words, there is no need to fear an audit just because you claimed the home office deduction. A high deduction-to-income ratio, however, may raise a red flag and lead to an audit.

What will qualify for a tax deduction as a home office?

As mentioned above, your workspace should be used “exclusively and regularly” as your principal place of business. Or it should generally be used exclusively and regularly as “a place where you meet or deal with patients, clients or customers in the normal course” of your business.

There are some additional tests for employee use. If you are an employee and you use a part of your home for business purposes, you may qualify for a deduction for its business use. However, to claim the home office deduction for employees you must meet the following conditions along with the ones mentioned above:

• Your business use must be for the convenience of your employer, and
• You must not rent any part of your home to your employer and use the rented portion to perform services as an employee for that employer.

Note: The Tax Cuts and Jobs Act suspended the home office deduction for employees from 2018-2025. Assuming this provision is not extended, employees will again be eligible for this deduction in 2026.

What factors related to the home office deduction could trigger an audit?

There are some factors that can trigger an IRS audit, such as-

• Not reporting all of your income or overstating your expenses/deductions
• Not making your payments on time or paying the exact amount
• Failure to file tax returns.
  However, one should keep in mind that in most cases, the home office tax deduction alone will not trigger an IRS audit, but it could be a red flag that, in conjunction with other factors, may result in a tax audit.

What are the qualified expenses?

Deductible expenses related to your home office include:

Rent

A percentage of your monthly rent is tax-deductible for every month you claim a home office expense deduction. With the high cost of rental properties these days, this deduction is a blessing.

Insurance

You can write off the cost of insurance (home/renter/property insurance) that covers the business part of your home.

Utilities

Basic utilities like electricity, gas, water, and trash removal are usually personal expenses and cannot be written off but you can write off a portion of these costs if you have a home office.

Home essentials

Cleaning supplies, soap, toilet paper, and other necessities are partially tax-deductible.

Home office furniture

Any furniture that you bought for your workstation is fully tax-deductible. You don’t have to take a percentage of these expenses, since they’re used exclusively meant for business activities.

Wifi bill

Internet connection is a necessity, especially if you are working from home. Thus, you can claim your wifi expenses on your taxes!

Property taxes

Just like the mortgage interest write-off, you can also deduct a portion of your real estate taxes.

Telephone

If you happen to have a landline connection, a portion of it can be written off.

Home repairs and maintenance

Any sort of home office repairs can be written off. However, if you are getting some renovation done to the entire house, then you’ll get a partial write-off.

What steps can you take to ensure that your home office deduction is accurate?

There are generally two major options available for taking the deduction:

• Regular method
• Simplified method

Once you qualify for the home office deduction, the next step is to figure out which method you want to use to calculate the deduction amount.

Regular method

The regular method writes off a portion of all home-related expenses. The deductions are based on the percentage of the home used for conducting business. Taxpayers who use a whole room or part of a room for conducting their business must figure out the percentage of the home used for business activities to deduct expenses like rent and utilities.

Simplified method

The IRS has set a rate of $5/square foot. The maximum size for this option is 300 square feet. The maximum deduction under this method is $1,500.

The simplified method comes to play if you had a home office in more than one home during the year. You can use the simplified method for one home, but any other home would warrant the regular method. You cannot use the simplified method for each home.

When it comes to opting for the ideal method, here are a few key considerations:

In almost every case, most CPAs and tax preparers will approve of the regular method since it provides a greater deduction for freelancers. However, everyone’s situation is different. At the end of the day, the regular method will typically offer a higher potential tax deduction, especially with effective tax planning, but it will also require you to keep more detailed documentation. The simple method requires minimal effort and documentation.

Conclusion

The home office expense deduction is slightly complicated but very beneficial. Generally, it all comes down to opting for the ideal method, you need to figure out the size of your home office and the calculations you want to make. You may choose either the simplified method or the regular method for any taxable year. However, you must remember that once you have chosen a method for a taxable year, you cannot change to the other method for that specific year.

If you use the simplified method for one year and resort to the regular method for any subsequent year, you must calculate the depreciation deduction for the subsequent year using the appropriate optional depreciation table. This is indisputable regardless of whether you used an optional depreciation table for the first year the property was used in business.

If the deduction seems too burdensome, FlyFin can help you perform the calculations and make the right decision. The app is powered by AI and backed by CPAs whom you can consult in order to determine which method works best for you.