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With more and more people setting up a home office, it is important to know what the IRS considers tax deductible. There are two tests that must be met in order to have your home office qualify for an allowable deduction. You must prove that you use your home office exclusively and regularly (on a regular basis) either as:
Use Form 8829 (Expenses for Business Use of Home) to report your home office deduction. This form will have expenses broken down into direct, indirect, and allocated.
A direct expense is 100% deductible since it is spent for just the home office. An example of a direct expense is maid service, decorating, and insuring your office equipment. Indirect expenses benefit both the entire house and your individual home office. Examples of indirect expenses include taxes, utilities, insurance, and mortgage payments are all considered valid expenses. An indirect expense needs to be deducted using a pro rata basis (described in next paragraph).
To properly report your home office expenses, you will need to know the square footage area. You will take this amount and divide by your home's total square footage to arrive at a percentage. This percentage is your applicable home office usage amount. You will use this percentage to allocate the qualifying operating expenses to your home office. All of this is explained more clearly on Form 8829.
If you use your home office for less than the full 12 months of the year, you need to prorate the usage. For instance, if you use your home office for 5 months, you will calculate your proration by 5/12 of your total office expenses.
Self-employed individuals benefit the most by the home office deduction. They regularly use their home office exclusively and regularly for administrative purposes.
Another area of concern for deducting a home office is in proving that you have a profit motive in your home office operations. You must meet the “3 of 5” test. This test shows the IRS that you have a profit motive and are not simply enjoying a hobby while claiming deductions. The 3 of 5 test states that if your business enterprise has made money for 3 out of 5 consecutive years, you have a profit motive.