Home Office Deduction for Landlords and Real Estate Investors

A landlord can deduct a home office only if the rental activity is a trade or business, not just an investment, and the space meets the regular and exclusive business-use requirements. The space must be the business's principal place of business, a qualifying place to meet clients or customers, or a detached structure used for the business. If you qualify, the simplified method deducts $5 per square foot for up to 300 square feet (up to $1,500 for full-year use), and the regular method deducts the office's share of actual home costs plus depreciation, which is taxed at up to 25% when you sell the home.

Do your rentals count as a business?

The deduction requires that you use the space in connection with a trade or business. IRS Publication 587 says a profit-seeking activity that is not a trade or business does not qualify, and its example is a person who uses a room only to manage their own investments.

IRS guidance on rental real estate describes the business test under section 162 of the tax code: you must be involved in the rental with continuity and regularity, and your main purpose must be income or profit. The answer depends on all the facts and circumstances, and material participation under the passive loss rules is not required. The IRS has said that a single property under a triple net lease, where the tenant pays the taxes, insurance, and maintenance, generally does not rise to a business.

Meeting the 250-hour safe harbor for the qualified business income deduction does not settle the question for a home office, because the IRS offers that safe harbor solely for that deduction.

The use tests: exclusive, regular, and qualifying business use

If your rentals are a business, the office itself must pass these tests:

• Exclusive use. You use a specific area only for qualifying business activities. It can be a room or a separately identifiable part of one, and it does not need a permanent wall. Any personal use, such as a guest bed or the family computer in that space, fails the test.
• Regular use. You use the area for the business on a regular basis. Incidental or occasional use does not count.
• Qualifying business use. The office qualifies as your principal place of business if you use it for administrative or management work, such as keeping books and records, billing, ordering supplies, and setting up appointments, and you have no other fixed location where you do substantial administrative or management work. Doing some of that work in your car or a hotel room, doing minimal work occasionally at another fixed location, or having a property manager handle tasks at its own office does not disqualify your home office. Publication 587 also accepts a space where you regularly meet clients or customers, or a separate detached structure used for the business.

A qualifying office also affects your mileage. Publication 527 treats drives between your home and a rental as nondeductible commuting unless your home is your principal place of business. Travel expense deductions for rental property investors covers the mileage rules.

How to calculate it: simplified or regular method

Simplified method. Multiply the office's square footage, up to 300, by $5 for full-year use of an unchanged area. For part-year use or changes in office area, add each month's qualifying square footage, capped at 300 per month, divide by 12, and multiply by $5. Count a month as zero if it has fewer than 15 days of qualifying use. You deduct no actual home expenses and no depreciation for the office, and your mortgage interest and property taxes stay personal expenses, deductible on Schedule A only if you itemize. You choose the method each year on a timely filed original return, and you can switch from one method to the other in a later year.

Regular method. Figure the business percentage, commonly the office's square footage divided by the home's. Apply it to the costs of running the whole home, such as mortgage interest or rent, property taxes, insurance, utilities, and general repairs; add costs for the office alone, such as painting it; and add depreciation on the office's share of the home. Depreciation is based on the smaller of the home's adjusted basis or its fair market value when office use began, not counting land, and runs over 39 years as nonresidential property, or 27.5 years if the home is an apartment in a residential rental building you own. How rental depreciation is calculated explains basis and first-year proration.

Example. Your home's building basis is $300,000, not counting land, and the office is 150 of the home's 1,500 square feet, or 10%, throughout the year.

The regular method deducts $2,209 more here. If you itemize, the $1,650 of interest and taxes is deductible either way (on Schedule A under the simplified method), so the real difference is $1,309 of other office costs against the simplified $750. If you take the standard deduction, the regular method is the only way to deduct the office's share of interest and taxes.

The simplified method caps the deduction at gross income from the business use of your home minus business expenses unrelated to the home. Under the regular method, expenses deductible without business use, such as qualifying mortgage interest and property taxes if you itemize, are not subject to this cap. Their business share instead reduces the income available for deducting home operating costs and depreciation, after subtracting the business's other expenses. If depreciation and other costs already leave your rentals at a tax loss (how rental income is taxed shows how that happens), part or all of the office deduction is limited. Under the regular method, office costs over the cap carry forward to the next year you use that method; under the simplified method, the excess is lost.

Where a landlord reports the deduction

Form 8829, the IRS home office form, is for Schedule C filers, and Schedule E has no home office line. The Schedule E instructions direct any ordinary and necessary rental expense not listed on lines 5 through 18 to line 19 ("Other"), which is where an office amount without its own line fits; the Schedule E deductions checklist shows what goes on the other lines. Figure the amount with the steps Publication 587 lays out and keep the calculation with your records.

If you report your rental on Schedule C because you provide substantial services, such as a short-term rental with regular cleaning and linen changes, use Form 8829 or the simplified method worksheet in the Schedule C instructions instead.

What happens when you sell your home

If you used the regular method, you cannot exclude the part of your gain equal to the depreciation you claimed, or could have claimed, after May 6, 1997, even if the rest of the gain qualifies for the home sale exclusion of up to $250,000 ($500,000 for qualifying married couples filing jointly). That amount is unrecaptured section 1250 gain, taxed at up to 25%. Because the office is inside your home, you do not split the gain between the office and the rest of the house, so the exclusion still covers the gain beyond the depreciation, up to its limit. Years under the simplified method add nothing, because the allowable depreciation for those years is zero.

Using the example above, 10 years of the regular method adds about $7,690 of office depreciation. At sale, that amount is taxed at up to 25%, or as much as $1,923, even if the rest of your gain is excluded. Weigh that later tax, up to $192 for each year's $769 of depreciation, against the yearly tax the regular method's larger deduction saves.

Keep proof of the office's exclusive use, such as photos and a floor plan with measurements, along with receipts for the home expenses you allocate and your depreciation calculation. Publication 587 says to keep records for the later of 3 years from the return's due date or filing date, or 2 years after you paid the tax, and to keep records of the home's basis and the depreciation you claimed. Tax audit protection for landlords covers the rest of a landlord's records.