As discussed in the article, Home Office Deduction Methods & the Simplified Method, sole proprietors, including Real Estate Agents, who have a qualified home office have two options available to claim their deduction: The Simplified Method and the Actual Cost Method. The Simplified and Actual Cost methods, as well as the relationship between the home office and the auto expense deduction, are covered extensively in our Real Estate Agent Comprehensive Tax-Cut Library. This article will introduce the Actual Cost Method and discuss direct and indirect home office expenses. In Part Two of our Actual Cost discussion, we will share the ins and outs of depreciating a home office.
Qualifying Home Office: To deduct a home office, it must meet the IRS definition of a qualified home office. A qualified home office is a separate structure on your property or a portion of your home (generally a room or part of a room) that is used regularly and exclusively as your principal place of business. To learn more about the rules for having a qualifying home office, read our article Real Estate Agents, Home Office Deduction Requirements.
Actual Cost Method Overview: The home office Actual Cost Method allows business owners to deduct the expense of operating their office. As you will see, the Actual Cost Method is more complex and time-consuming than the Simplified Method, which allows a $5.00 deduction per square foot of office space (up to 300 square feet). It also requires a substantial amount of recordkeeping to calculate and substantiate the deduction claimed. This increased complexity and recordkeeping, however, may generate a higher deduction for many Real Estate Agents, especially agents who:
- Own expensive homes with high mortgage interest and property tax costs.
- Have home offices that occupy a high percentage of their home’s total square footage.
- Have offices located in a separate structure on the property of their primary residence.
- Rent their homes.
Unlike the Simplified Method, which is calculated on Schedule C, the Actual Cost Method requires the completion of a separate form, Form 8829 Expenses for Business Use of Your Home. It also requires separating what are called direct and indirect expenses and depreciation of the structure or portion of the home containing the home office.
Actual Cost Loss & Limits
Unlike the Simplified Method, which cannot generate a loss on Schedule C, certain actual expenses can be deducted, even if they create a loss. Another difference between the simplified and actual cost method is that simplified expenses creating a loss are gone forever. Non-deductible actual cost expenses, however, can be carried forward to the following tax year.
When using the Actual Cost Method, costs that are also itemized deductions (mortgage interest and real estate taxes) can be deducted even if they create a loss on Schedule C. All other expenses, including depreciation, must be carried forward to following years until they can be deducted.
Square Footage Calculation
Both the simplified and actual cost office deduction methods require calculating the size of the home office and the size of the home. For the Actual Cost Method, these measurements are needed to determine the percentage of the house or apartment used for business. Although a variety of measures are allowed under the actual cost method (as long as they accurately reflect the size of the home office relative to the size of the home), square feet is by far the most common measurement unit.
Calculating square footage is relatively easy. The basic formula for homes offices that are square or rectangular is to multiply its length by its width. If you have an oval or irregularly shaped office or home, you may need to dust off your high school geometry book.
Sticking with normal-shaped rooms, let’s say, you have a spare bedroom that is a qualifying home office. Its length is 14 feet; it is 12 feet wide. The size of the office is 14’ * 12’, or 168 square feet.
The square footage of your home is generally considered the amount of living space in your home. Some interpret the term living space as all areas that have electricity, heat, and air-conditioning. Others believe living space only includes finished portions of the home unless an area is used for business storage. Opinions vary – the key is to be reasonable and consistent in your measurement. If your home is a single story 60 feet long and 45 feet wide, it is 2,700 square feet (60 * 45). This is a basic, acceptable calculation. If you have time to measure and add up the square footage of every single room in your home, including the office, feel free to do so. It may lead to a slightly higher percentage, and, therefore, more significant deduction.
To determine the percentage of your home that is used for business, divide the square footage of the home office by the total square footage of the home. Following the calculations above, this is 168 divided by 2,700. The answer is .0622, or 6.2%.
Office Part of Room: If your qualifying home office is part of a room, for example, a desk and filing cabinet in the corner of a bedroom, your home office will be the area where the desk and cabinet are located. It may also include the foot or two beyond this area needed to sit at the desk and perform business duties, provided this space is used exclusively for business.
If your desk, filing cabinet, and your chair where you work take up an area that is 7 feet in length by 4 feet in width, it is 28 square feet (7 ft*4 ft) if your home is 2,700 square feet, your business-use percentage is .0103 or 1.03% (28 divided by 2,700). If this seems like such a small percentage that taking the home office deduction is not worth the hassle, remember that the primary benefit of having a qualified home office is its potential to increase your Auto Expense Deduction.
The home and home office square footage and the home office percentage are reported on Form 8829 and needed to allocate certain costs of your home office. In our Real Estate Agent Comprehensive Tax-Cut Library and Auto and Home Office Deduction for Real Estate Agents course, we cover completion of Form 8829 in detail, step-by-step. Form 8829 requires that direct costs and indirect costs be reported separately for the home office. The rules also require that a home office that is owned (not rented) be depreciated. In the remainder of this article, we’ll discuss the basics of direct vs. indirect home office costs. Depreciation will be covered in part two of the actual cost series.
Direct costs are expenses that are exclusive to the office and not shared by other parts of the home. These costs are reported in Column A of lines 9 through 23 of Form 8829. Direct expenses are especially common when the office is a separate structure on the agent’s property and individually metered for electricity, water or sewer.
Offices inside your home can also incur direct expenses. Painting the home office or repairing an electrical outlet inside the office are examples of direct expenses. I have also had situations in which an office inside the home has its own heat source. In this situation, the cost of heating oil or firewood to heat the office is a direct expense.
Indirect Costs are expenses shared by both the home and the home office. Allocating indirect costs is why the home office percentage is calculated. Indirect costs are reported in full on Column B of Form 8829. Their total is then multiplied by the business-use percentage to determine the deductible amount. For example, if your total indirect expenses are $4,500 and your home office takes up 8% of the square footage of your home, your deductible indirect costs are $360 ($4,500 * 8%).
Indirect costs include (but are not limited to) a variety of expenses incurred by the home as a whole. This includes mortgage interest, property tax, renters or homeowner’s insurance, rent, repairs & maintenance, utilities, HOA Dues, as well as fire and ambulance fees.
Several factors can complicate the calculation of indirect expenses. Here’s a brief list:
- Itemized deductions that are also indirect costs such as mortgage interest and real estate property tax must be adjusted before claiming them as itemized deductions. Amounts deductible as an indirect expense must be subtracted from the amount claimed as an itemized deduction to ensure these amounts are not double counted.
- Home equity lines of credit and second mortgages are not deductible as a home office expense unless the proceeds were used to substantially improve the home (indirect) or home office (direct expense).
- Avoid deducting expenses that are not shared by the home office. For example, paying to have the kitchen stove repaired might be a repair expense, but it’s probably not an indirect expense for a Real Estate Agent’s home office. On the other hand, paying $400 to have the HVAC fixed is an indirect expense if the HVAC heats and cools the home office as well as the rest of the home.
- The first telephone line to the home is not considered a business expense, even if it is used for business. It is neither a direct or an indirect expense. A second telephone line, such as a dedicated fax line or a phone line used for a security system can be deductible as a direct or an indirect expense depending on how it is utilized.
Note on Capitalization
Certain items and significant repairs may need to be capitalized (meaning they are expensed over time as depreciation and not as an expense in the year purchased). This can be true for both direct and indirect expenses. For example, $6,000 to replace an HVAC unit for the whole house is the purchase of an asset that needs to be depreciated as an indirect expense. In this case, depreciation would be deducted on Form 8829. On the other hand, if the HVAC unit is used exclusively by the home office, it would be a direct expense. Direct depreciation is not reported on Form 8829. It is deducted on Schedule C.
Take Away: The Actual Cost Method for taking the home office deduction can be complicated and cumbersome. It will, however, generate many agents a substantially larger deduction than the Simplified Method. If you find some of these rules make little sense, you are not alone. To most folks, they don’t (and we haven’t even discussed home office depreciation yet)! This is why we recommend agents deducting actual home office expenses hire a professional to prepare their returns.
Summary and Invite: We hope this article helped you to better understand the home office deduction as well as direct and indirect expenses. If you’d like to learn more about cutting your most significant expense, TAXES, check out our Real Estate Agent Tax Cut Library. The Real Estate Agent Tax Cut Library includes over eight hours of video broken into twenty-nine searchable volumes and covers every possible deduction a Real Estate Agent can take on their tax return. Our Broker Version will help your entire agency cut their taxes! We also invite you to browse our courses.