The home office deduction for small business owners has a reputation as the thing that gets you audited, and plenty of small business owners skip it for years because a relative once told them to. The rules themselves are pretty tame, and the IRS lays them out in Publication 587, a document that’s drier than a July cornfield but more readable than you’d expect.
What actually trips people up is the detail work, so we’ll walk through how the deduction works, where Illinois fits in, and the mistakes we see most often around Edwardsville and St. Louis.
The Home Office Deduction Starts With How You Use The Room
In practice, the IRS cares far less about how nice the room is than about two tests: you use the space regularly and exclusively for business, and it’s either your principal place of business or a place where you meet clients, as spelled out in the IRS home office rules.
Principal place of business has a friendlier definition than most people expect. If you handle your administrative work at home (invoicing, scheduling, ordering supplies) and there’s no other fixed location where you do a substantial amount of it, the office can qualify even if you spend most of your day on job sites, which is good news for the electricians and landscapers around Collinsville who run the business from a back bedroom.
A separate structure, like a detached garage or workshop, can qualify too, as long as you use it regularly and exclusively for the business. And because the deduction is only as good as the records behind it, tidy expense tracking is a big part of what our monthly bookkeeping clients get from us year-round.
The regular-use half of the test is easy for most owners, while the exclusive-use half is where the trouble usually starts, so that’s where we’ll go next.
What Does Regular And Exclusive Use Mean For The Home Office Deduction?
Exclusive use means the space is used only for your business, so a desk in a corner of the family room can count if that corner really is business-only, while a dining table that hosts both invoices and Thanksgiving dinner won’t. The space doesn’t need walls or a door, but it does have to be a separately identifiable area.
Regular use means a continuing basis, and the IRS says in Publication 587 that incidental or occasional business use doesn’t meet the test. There are two exceptions to the exclusive-use rule, one for storing inventory when your home is the only fixed location of a product business and one for a licensed daycare.
Let’s look at an example. This one is an illustration rather than a specific client: picture an owner who has claimed an entire spare bedroom for years, and when we ask about the room, it turns out it also holds the family treadmill and a pull-out couch for visiting in-laws.
We wouldn’t throw the deduction out in that situation. We’d measure the part of the room that’s truly business-only and claim that instead, which gives a smaller number but one you can defend, and the treadmill gets to stay.
Once the square footage is settled, the next decision is how to turn it into a deduction, and the IRS gives you two ways to do that.
Simplified Method Vs Actual Expense Method: Which Home Office Deduction Is Bigger?
It depends on your house, but the simplified method is often the smaller and almost always the simpler of the two, since the IRS simplified option lets you multiply your office square footage by $5, up to 300 square feet, for a maximum of $1,500 a year.
The actual expense method takes your office’s share of the home, usually its square footage divided by the total, and applies that share to your real costs on Form 8829, so an office that takes up 10% of the house gets 10% of the shared expenses.
For a bigger office, a home with a lot of mortgage interest, or a hefty Madison County property tax bill, actual expenses can pull ahead, though we’d want to see your numbers before calling it either way.
With the simplified method, you don’t take depreciation, and you can’t carry an unused amount forward, while the actual method lets you carry over what your business income couldn’t absorb, and Publication 587 lets you switch methods from year to year.
If the actual method looks promising for your situation, it helps to know exactly what goes into it before you start digging through utility bills.
The Actual Expense Method Covers More Of Your House Than You’d Think
For most homeowners, the list includes the business share of mortgage interest, real estate taxes, homeowners insurance, utilities, general repairs, and depreciation on the house itself. Renters use the business share of rent in place of mortgage interest and depreciation, which makes their math a lot simpler.
Expenses that only benefit the office, like painting that room, are direct expenses and are generally deductible in full, while costs for the whole house get split by your business-use share. Costs that only benefit the rest of the house, like redoing the kitchen, aren’t deductible at all, no matter how much you’d like the new countertops to count.
Depreciation is the piece people underestimate, and under the IRS home office rules the office portion of your home is depreciated as nonresidential real property over 39 years, based on the lower of your adjusted basis or fair market value when you started using the space, not counting the land.
All of that assumes you own the business directly as a sole proprietor or single-member LLC, and S-corp owners play by a different set of rules.
S-Corp Owners Claim The Home Office Deduction Through An Accountable Plan
For an owner who works in their own S-corp, the catch is that you’re also an employee of the company, and the IRS simplified option page says taxpayers can no longer claim a home office deduction as an employee.
Being an employee of your own company also means you’re on its payroll. If that’s new territory, our guide to payroll setup for a first employee walks through what Illinois expects from Metro East owners. It’s easier to get payroll in place first, then layer the accountable plan on top.
The fix is an accountable plan, a written policy where the company pays you back for business expenses you document. When the plan follows IRS Publication 463, the reimbursement isn’t reported as pay, so it isn’t taxed to you as wages, and the company generally treats it as a business expense.
The expense needs a business connection, you have to account for it within a reasonable period, and you return anything the company overpaid, with Publication 463 treating an accounting within 60 days as reasonable. The same plan can also reimburse business meals you pay for personally, which we cover in our updated meal deduction guide.
We usually recommend adopting the plan in writing (yes, even when the board of directors is just you) and submitting an expense report within 60 days, monthly is easiest, using the same square footage math, which is one of the first things we set up for new S-corp clients as part of our business tax planning work. If you’re weighing the S-corp for other reasons, our post on the Section 199A QBI deduction for Illinois and Missouri small businesses covers how entity choice affects that deduction too.
Whichever way you claim it, the deduction leaves a footprint that shows up again when you eventually sell the house.
Depreciation Recapture Is The Home Office Deduction’s Long Tail
When you sell a home where you had an office, IRS Publication 523 says you generally can’t exclude the part of your gain equal to depreciation you claimed or were entitled to claim after May 6, 1997, even if the rest of the gain is covered.
The home sale exclusion itself covers up to $250,000 of gain, or $500,000 for most married couples filing jointly, if you meet the ownership and use tests in Publication 523.
The depreciation portion is taxed as unrecaptured section 1250 gain, which is the IRS name for gain that comes from depreciation on real estate, and the IRS capital gains topic caps the federal rate on it at 25%.
The words entitled to claim are the part that stings, because skipping depreciation on the actual method doesn’t avoid recapture, so you’d lose the deduction on the way in and still owe on the way out. The simplified method sidesteps this, since there’s no depreciation for those years, which is one reason we sometimes lean toward it for owners who expect to sell in the next few years.
Recapture is the most expensive surprise on this list, but it isn’t the most common mistake we run into, which brings us to the last section.
Home Office Deduction Mistakes We See With Illinois Small Business Owners
Claiming a full room when only part of it is business-only tops our list, followed closely by S-corp owners putting the office on their personal return instead of running it through an accountable plan.
Illinois adds its own wrinkle, because your state return starts from your federal adjusted gross income, so a home office deduction that lowers your federal business income also lowers the income Illinois taxes at its flat 4.95% individual rate. That cuts both ways, since a federal mistake usually means your Illinois return is off too, and amending your federal return generally means filing an amended Illinois return behind it.
The other one we see is double-counting, where mortgage interest and property taxes show up in full on Schedule A and again on Form 8829. If you’re self-employed, the home office also lowers the income your quarterly estimates are based on, which we covered in our guide to quarterly estimated taxes for Illinois self-employed owners.
None of these are hard to fix before you file, which is why it’s worth having someone look over the setup first.
If you also run a second entity or rent a building to your own company, our post on multi-entity reporting for growth-stage businesses is a good next read.
And if you’d like someone to look at your home office setup before you file, reach out to the team at Thompson Flaherty. There’s zero pressure, and we promise not to judge the treadmill.
Talk soon.
