As a self-employed sole proprietor you can deduct as an ordinary and necessary business expense the costs of a qualifying home office on Schedule C.
If you are an employee of your own one-man corporation, whether a regular "C" corporation or a "sub-chapter S" corporation, you have three choices for handling the costs of a qualifying home office:
You can deduct the costs as an unreimbursed "employee business expense" under "Job Expenses and Most Other Miscellaneous Deductions" on Schedule A. Expenses in this category of itemized deduction are only deductible to the extent that the total exceeds 2% of your Adjusted Gross Income.
The corporation can pay you rent for the home office.
The corporation can pay you for the costs of a home office under an "accountable" plan for employee business expense reimbursement.
The third option, being reimbursed under an accountable plan, provides the greatest tax savings. It is an excellent way to get money out of your closely-held corporation tax-free. The corporation can deduct the amount of the reimbursement and you do not have to report the payment as income.
This option is "more better" than having the corporation pay you rent for the home office. While your corporation can deduct the rent paid to you, you must report the rent as income on Schedule E. You can only deduct the pro-rated share of real estate taxes, mortgage interest and casualty losses against the rental income on Schedule E, expenses that are otherwise deductible in full on Schedule A. You cannot deduct the proportionate share of any other expenses "with respect to the use of [the] dwelling". While this generally includes insurance on the dwelling, repair and maintenance on the dwelling, depreciation on the dwelling, and certain other indirect expenses, it does not include expenses which are not "with respect to the use of [the] dwelling" (such as the cost of electricity used to power office lights and equipment).
To qualify as a home office, the space (it does not have to be an entire room) must be used regularly (on a continuous, ongoing or recurring basis) and exclusively (there can be no personal use) for your trade or business, and it must be your principal place of business or a place where you physically meet with patients, clients or customers on a regular basis. The space will be considered your principal place of business if it is used for performing administrative or management activities, such as billing, bookkeeping, ordering supplies, setting up appointments and writing reports, and there is no other fixed location where you regularly perform these activities.
As an employee the home office must be for the convenience of your employer. This means the home office is required as a condition of employment, it is necessary for the business to function or it is necessary for you to properly perform your duties as an employee. If you do not have any other place of business, such as a rented office or storefront, your home office should qualify.
I used to rent an office for my tax practice. Even though I did administrative work in a "regular and exclusive" space at home, and on rare occasions met with clients there, I could not claim a home office deduction or be reimbursed for home office expenses. I have since given up the rented office and work exclusively out of my home. I now have a qualified home office.
For an expense reimbursement plan to be considered "accountable", the expenses that are reimbursed must be for actual job-related expenses (you cannot reimburse personal expenses) and you, as the employee, must substantiate the expenses by providing your employer with receipts or other documentation.
You should create a monthly "Employee Expense Report" form for your corporation. This is a good idea whether or not you have a home office. Start out with lines for business mileage and other out-of-pocket business expenses, such as postage, office supplies, parking and tolls, meals and entertainment, etc. Staple receipts for these items to the report.
Include a Home Office section in the report. Calculate the "business use percentage" of your home office by dividing the square footage of the office area by the total square footage of the home. List each item of expense paid during the month, such as real estate taxes, homeowner's insurance, oil heat, gas and electric, water and sewer, alarm or security service, garbage disposal, general repairs and maintenance, and mortgage interest (taken from the monthly mortgage billing statement or a loan amortization statement you can create online). Multiply the total of these expenses by the business use percentage to determine the amount to be reimbursed.
Total up all the business expenses listed on the form, including the home office amount, and write a check from the corporation to yourself for this amount.
You must reduce the amount of your itemized deduction for real estate taxes and mortgage interest by the amount of reimbursement you receive from your corporation during the year for these items. If your real estate taxes for the year are $10,000, but in the course of the year you were reimbursed $2,000 by the corporation, you can only deduct $8,000 in real estate taxes on Schedule A.
Deducting, or being reimbursed for, a home office today will no longer turn around and bite you in the arse when you sell your personal residence, as had been the case in the past. If the home office is within the same "dwelling unit" as the residential portion of your home, you are treated as using the entire home as a principal residence.
If the office space was 10% of the total area of your home, you DO NOT have to pay income tax on 10% of the gain from the sale. You will be able to exclude the entire gain, up to the $250,000 or $500,000 limits, if you qualify, less any "post-May 6, 1997" depreciation. You must report any depreciation you deducted on the home office after May 6, 1997 as "unrecaptured Section 1250 gain", which will be taxed at the capital gains rates up to a maximum of 25%.
You are married and you sell your personal residence, which you owned and lived in for the past 4 years and in which you had a qualified home office that was 15% of the total area, for a net gain of $300,000. During the 4 years you lived in the home you were able to deduct $5,000 in depreciation on the home office portion. You can exclude $295,000 of the gain, and will pay tax on only $5,000.
If you were not able to deduct depreciation on your home office, or were not reimbursed by your corporation for depreciation, there is no income to report and 100% of the gain, up to the limits, will be tax-free.