How Do You Deduct Home Office Expenses?

A landlord can deduct home office expenses only if the rental activity is run at the level of a business and a specific area of the home is used regularly and only for managing it. If you qualify, you deduct either $5 per square foot of office space, up to 300 square feet ($1,500 for a full year, reduced for part-year use), or the office's share of your actual home costs during qualifying use, as a rental expense on Schedule E. With the actual-cost method, office depreciation can be taxable when you sell your home, but only to the extent you have gain after accounting for depreciation.

Does your rental activity qualify for a home office?

The IRS applies three tests, and you must meet all of them. If the deduction is ever examined, the IRS decides whether you met them based on your records.

1. The rental activity is a trade or business. The home office deduction is for a business, not for managing investments. IRS Publication 587 gives the example of an investor who reads reports and tracks a personal portfolio from home: that person cannot take the deduction. Owning rentals is not automatically a business. The Supreme Court's test in Commissioner v. Groetzinger (1987) asks whether you are involved with continuity and regularity and whether your main purpose is income or profit. A landlord who screens tenants, collects rent, arranges repairs, and keeps the books for several units throughout the year has a stronger case than the owner of one house leased long term with a property manager handling everything.

2. Regular and exclusive use. You must use a specific, identifiable area only for the rental business, on a regular basis. It does not need walls, but a den the family also watches TV in, or a guest room with a desk, fails the exclusive use test. Occasional use is not regular use.

3. Principal place of business. The office qualifies when you use it for the administrative and management work of the rentals, such as bookkeeping, tenant communication, scheduling repairs, and ordering supplies, and you have no other fixed location where you do substantial amounts of that work. Doing repairs and showings at the properties does not disqualify the home office. A detached structure, such as a workshop in a garage separate from the house, can qualify without the principal place test if you use it regularly and only for the rentals.

A qualifying office also changes your car deductions. Trips from home to a rental are normally nondeductible commuting, but when your home is the principal place of business for the rentals, those trips become deductible local transportation.

How do you figure the deduction?

You can choose either method each year.

Simplified method for part-year use. For each month, count up to 300 square feet only if the office qualified for at least 15 days; otherwise count zero. Add those monthly amounts, divide by 12, then multiply by $5.

Actual-cost method. Use only expenses for the period the office qualifies. Divide the office's square footage by the home's total. Multiply that percentage by your indirect costs: mortgage interest, property taxes, homeowners insurance, utilities, general repairs, and HOA dues, or rent if you rent your home. Add direct costs, such as painting only the office, at 100%. Then add depreciation on the office share of the home. Use the smaller of your adjusted basis (generally purchase cost plus permanent improvements, minus prior depreciation and losses from damage or destruction) or fair market value, excluding land, at the time you began using the office, and depreciate it over 39 years as nonresidential property. For the first year, use the percentage in Publication 587's depreciation table for the month business use began instead of a full year's depreciation.

Example

Assume the office qualifies all year, its first year of business use has passed, and rental income is enough to deduct these costs. Your home is 2,000 square feet and the office is 200 square feet, so the business percentage is 10%. Your home costs for the year are $12,000 of mortgage interest, $5,000 of property taxes, $1,800 of insurance, $3,600 of utilities, and $600 of general repairs, a total of $23,000.

• Office share of home costs: $23,000 × 10% = $2,300
• Depreciation: the house (excluding land) has a $300,000 basis, so the office share is $30,000, and a full year is about $769 ($30,000 ÷ 39)
• Actual-cost deduction: about $3,069
• Simplified deduction: 200 × $5 = $1,000

The actual method gives the larger deduction here. Of that $3,069, $1,700 is the office share of mortgage interest and taxes, which you could otherwise deduct on Schedule A only if you itemize. Moving it to Schedule E also keeps the $500 property tax share out of the state and local tax (SALT) cap, which applies only to taxes deducted on Schedule A.

The income limit

Under the actual-cost method, the office share of mortgage interest and property taxes escapes the home office income limit only if you itemize and those amounts would otherwise be deductible on Schedule A. The business share is subject to the limit if you take the standard deduction or amounts exceed personal deduction limits. Other office expenses, including interest and taxes subject to the limit, can use only the rental income left after other rental expenses and the otherwise deductible interest and taxes. Depreciation comes last. In a rental loss year, only the otherwise deductible itemized amounts escape the limit. Disallowed actual costs carry forward to a year you use that method.

The simplified method allows no separate business deduction for mortgage interest or property taxes, and no home office deduction if rental income minus other rental expenses is zero or negative. Unused simplified deductions do not carry forward.

Where do you report it on a Schedule E return?

Form 8829 is the home office form for Schedule C filers, and the simplified method worksheet appears in the Schedule C instructions. A landlord reporting on Schedule E uses the same rules from Publication 587 but has no dedicated form. Figure the deduction on a worksheet, keep it with your records, and claim it as a rental expense on Schedule E. If you itemize, reduce the mortgage interest and property taxes on Schedule A by the office share you moved to Schedule E so the same dollars are not deducted twice. If you claim depreciation on the office for the first time, attach Form 4562.

A desk, file cabinet, computer, or printer used for the rentals is deductible or depreciable whether or not the room qualifies as a home office. Office furniture is 7-year property and computers are 5-year property. See the full list of rental operating expense deductions for supplies, software, and phone costs.

What happens when you sell your home?

If the office is inside your house, you do not split the gain between the office and the rest of the home. The full gain can qualify for the home sale exclusion of up to $250,000, or $500,000 for married couples filing jointly, if you meet the ownership and use tests. The exception is gain attributable to depreciation. Gain up to the depreciation you claimed, or were entitled to claim, on the office after May 6, 1997 cannot be excluded. It is taxed as unrecaptured section 1250 gain at a maximum rate of 25%.

Suppose your total office depreciation at sale is $3,845. If your sale gain after reducing basis for depreciation is at least $3,845, that amount is taxable at up to 25%, about $961 at most, while the rest of the gain stays eligible for the exclusion. If your gain is smaller, only that gain is taxable; with no gain, none of the depreciation is taxable. If you used the simplified method in every year, the depreciation for those years is treated as zero and there is nothing to recapture. If you qualified under the actual method but did not claim depreciation, the IRS still reduces your basis by the amount you could have claimed.

If the office is in a separate structure, such as a detached garage, the rules differ. The gain on that structure is not covered by the home sale exclusion and is reported separately, unless you used the structure as part of your residence for at least 2 of the 5 years before the sale. Any gain attributable to depreciation remains taxable even if you meet that residence test.

For how the home office fits with your other rental deductions, including mortgage and other loan interest, see what rental expenses landlords can deduct.