After reviewing more than a thousand tax returns for traders and small business owners, there’s one deduction that is regularly either missed or under calculated. Upon inquiry, the typical response for not taking the most they’re allowed is, “I didn’t want to get in trouble.” For the benefit of all the traders out there, I want to expound this topic and put some myths to rest.
Home Office Deduction
We’re talking about the home office deduction. The IRS allows two methods to calculate your deduction: Regular Method or Simplified Option. Once you choose a method, you need to stick with it. A word of caution here is that, when it comes to taxes, simple rarely equates to savings. There are times I encourage the use of the Simplified Option, but eight out of ten times the Regular Method yields a deduction three to five times bigger.
Am I Allowed to Take It?
There are two major rules when taking a home office deduction. The IRS explains, your home office must be your principal place of business and be used regularly and exclusively. The first requirement is flexible since in that same paragraph the IRS says, “The structure does not have to be your principal place of business or the only place where you meet patients, clients, or customers.” As far as being used regularly, what successful trader does not trade regularly? So, the biggest area of concern for most traders is “exclusive use.”
Myth #1: You need an entirely dedicated room to take the home office deduction.
False. The wording reads “part of your home” not “room.” So, if you rent a studio apartment and your trading desk is next to your bed, well then the space that your computer, desk, chair, and bookshelf occupy counts for exclusive use. Furthermore, the space does not need to be contiguous. Many forget they have a bookshelf, filing cabinets, computer parts, a favorite chair, or a table spread throughout their home that they regularly use for business. All that space adds up!
Myth #2: You can’t use your home office at all for anything personal.
Mostly true. Aside from the fact it would be very hard for the IRS to prove you are using your office for personal activities, my experience has been that the IRS understands you’ll check your personal email, listen to internet radio and eat while in your home office. My employer wouldn’t be surprised if I admitted to occasionally calling my family while in my office at work. Just because personal use is incidental to working does not violate the exclusivity rule.
Can I Deduct My Security System or Pest Control?
Would you expect the office landlord to keep the unit secure from thieves and free of pests? Absolutely! When calculating the home office deduction, there’s two types of expenses: direct and indirect. Most home office expenses are indirect costs for keeping up and running your entire home, as explained in IRS Publication 587. This includes water, trash, electric, repairs, security, pest control, cleaning supplies, internet, cable, phone, and the list goes on. Even property taxes, mortgage interest, PMI, and depreciation get allocated. Imagine you rented out a separate office space.
All these costs of maintaining your home get thrown into a big bucket then allocated to the home office based on the percentage of business use. As a ballpark, the allocated expenses usually add up to three to four times your monthly mortgage.
In addition to the indirect expenses, the home office deduction includes 100% of direct expenses. So, if you need to build out, expand, make repairs, or run wiring directly to your home office, then those expenses are included 100% without being allocated.
Myth #3: If I include depreciation, then I will be subject to depreciation recapture later.
This is misleading. Because IRS Publication 544 explains depreciation recapture is based on depreciation that was “allowed or allowable,” this means that if you were allowed to take depreciation, even if you didn’t claim any, you’re still subject to depreciation recapture. So technically, the opposite of the myth is true too: “If I do not include depreciation, I will still be subject to depreciation recapture later.”
But trust me, this is almost always to your favor. I’ve run the numbers many times with clients over the years and it always made sense to claim the depreciation. Not to mention, if you’ve paid off your mortgage this is one of the biggest components of your home office deduction.
Myth #4: Home office deductions are red flags for the IRS to audit me.
Playing the “audit lottery” is not a best practice. While I don’t have a crystal ball into the Discriminant Function System and algorithms the IRS uses to select returns for examination, many statistics have been provided showing certain groups of returns are more likely to be audited. In short, the more complex your return and the more money you make, the more likely you might receive a letter in the mail asking to verify some information. In general, simple tax returns run a low risk of audit, roughly 1% while some very complex returns may have a risk of around 2-3%.
We don’t recommend anyone take uncertain positions just because they think they won’t be audited. It is better to have a quality tax return prepared by a high caliber tax firm with the correct experience and expertise than to take unfounded positions based on guesses and chances.
Not sure you’ve got the right preparer? OTA Tax Pros is here to help! We consult with hundreds of traders every year and can guide you in your specific situation.