Home Office Expenses

How to Claim Your Tax Deduction

Home based businesses receive some favorable tax treatment in Canada. Claiming your home office expenses as a tax deduction on form T2125 is one tax saving opportunity you don't want to miss when doing your tax preparation this year ... or any year.

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The calculation of Business Use of Home expenses is found on page 3 of Form T2125 Statement of Business or Professional Activities.

To claim this tax deduction, you are going to have to gather some information and meet some strict criteria, laid out by the Canada Revenue Agency (CRA) in Guide T4002, Business and Professional Income.

While tax time isn't everyone's cup of tea, saving on taxes legally is. So let's get started.

Reminder

Before I begin I would like to remind you there is a difference between information and advice. The information provided in this article or on this site should not be construed as advice. Please make yourself familiar with my disclaimer.

Do You Qualify for the Home Office Expense Deduction?

The Jacks Institute Small Business Tax Course provided some background history for the home office expense deduction which I am going to share with you ... now. ;-)

Prior to 1988, there were no restrictions on deducting home office expenses to offset other earned income. Since 1988, some restrictions apply ... I didn't say the background history would be long winded! :O)

CRA's Guide T4002 tells us you can take the home office expense tax deduction if you meet one of the following conditions:

1. It is the principal place of business; OR

2. The space is used exclusively to earn business income on a regular AND continuous basis for meeting clients, customers or patients.

Notice that in the first criteria ...

... if you use part of the home for both business and personal living (ie. not exclusively to earn business income) OR ...

... you have an exclusive work area but you do not meet customers on a regular basis on your premises ...

... you must prorate your claim based on hours of use in a day and days of use in a week. See how to prorate expenses for more information.

The examples CRA give in Interpretation Bulletin IT-514 are farmers and contractors. The T4002 Guide uses hairdressers that work from their home but do not have an exclusive portion of the home set aside for the business ... as an example.

I would expect if you were a virtual business (do business over the internet) you would fall in this category as you would not meet customers on your premises.

If you are claiming under criteria one, Canadian tax expert Evelyn Jacks recommends you make and date a sketch of the business use area in relationship to the personal living space of the house. Keep it on file in the event of an audit to provide support documentation for your claim.

The second criteria has two parts ...

... both of which must be met.

First, the work space must be segregated and used only for business and no other purpose.

The second part of this criteria is regular meetings. In this instance you want to ensure you keep an appointment log as proof for CRA if audited. A Business Journal is also a good idea.

It means that if you have a business that has infrequent or irregular meetings, you DO NOT meet this criteria and you must prorate your claim based on hours of use in a day and days of use in a week.

Tom Koppel, former CPA has some additional suggestions on how to document use of your home office in his American Home Business Taxes article ... that would work here in Canada too. I've listed two of them here for easy reference.

• Photograph your office and your business meetings in your office.
• Have a register that clients sign when they come to your office.

There are Restrictions on the Deduction

Once you determine you have met the criteria to take the business use in home expense tax deduction, be aware the deduction has limitations.

It cannot be used to create or increase a loss for income tax purposes. However, it can be carried forward indefinitely if you are unable to use it in the current year AND continue to meet the criteria to make the claim.

Any carried forward expenses will have to be used up in any year there is business income, to reduce your income to zero.

Also be aware that your home telephone line, consumed supplies and similar expenses are not deductible under this section as they do not relate to the work space itself.

I have noticed on a few sites with bookkeeping tips, they mention you can deduct your home phone line here under this section ... but it clearly states in point 4 of Bulletin IT-514 that you can't.

I probably don't have to say this, but just in case, you can only ever deduct an expense of any kind ONCE ... so if you claim something under business use of home expense, it cannot be deducted anywhere else!

Should You Claim Capital Cost Allowance?

The self-employed in Canada have the option to claim capital cost allowance (CCA) and mortgage interest in the calculation of this tax deduction.

Tax experts don't usually recommend you take advantage of the opportunity to claim CCA. Why? ... because it is subject to capital gain and recapture rules which removes the tax exempt status of a portion of your home as a principal residence.

What does this mean? It means you would have to pay capital gains on the depreciated portion of your home ... in the future when you sold it.

Change of Use of Principal Residence is discussed in the comments section of this forum question on home office expenses and again in this forum question.

How to Prorate Home Office Expenses

Once you have gathered the eligible home office expense original source documents as listed on form T2125 ... which include utilities including water (but not your telephone), maintenance and repairs, insurance, property taxes, rent, mortgage interest ... you must prorate them to your office space.



To calculate the percentage of expenses related to your home office that are deductible, perform the following calculation ... keeping in mind the above discussions on which criteria you fell under.

Business Use - Criteria One

Square footage of office space / total square footage of home
  x hours in operation each day / 24 hours
  x days in operation each week / 7 days
  

Business Use - Criteria Two

Square footage of office space / total square footage of home

The old forms had a space for these calculations right on the worksheet. With these new forms, you have to back out the personal use part instead ... so it becomes even more important to keep your notes on how you made your calculation.

Once your worksheet is complete, you (or your tax program) carries the amount up to page 2 of Form T2125 to line 9945. If there was an amount carried forward from the prior year, you will see it in your worksheet just under the capital cost allowance.

Things to Consider - Home Office Expenses to Include ... Home Office Expenses to Exclude

Eileen Reppenhagen, CGA is a tax researcher, author and speaker. She believes in educating people to improve their financial and tax literacy. Please do not consider the following tax advice. As Eileen says, "This is not tax advice, it's tax education."

On her site TaxDetective.ca (you may want to take a look at this site), she has some "Points to Ponder" when considering your home office deductions. I've thrown in some of my own ponderings as well. I'm going to list the home office expense deductions in the reverse order they show on Form T2125.

In British Columbia, you can apply to defer your property taxes beginning at the age of 55 ... although I don't know why you would want to as it may affect your future borrowing power against your home equity in times of emergencies.

Banks like to have first claim to your collateral. I have a friend who is a bank manager and she says they would want you to pay off your back taxes before they would consider loaning you money with your home as collateral. That would be awful news to hear if you are having a financial crisis and need to borrow money.

Anyway, if you do go this route, Eileen says your deferred property taxes are still claimable. What she isn't sure about is whether the grants should reduce the claim.

I like to be conservative in my tax saving strategies (it's just my nature and I can't afford to be the one to challenge the government) so I would reduce the taxes to the amount I actually paid. Why? Because all rebates, grants, assistance must offset the expense or be claimed as income. Read more here in point 2 of Home Business Taxes Part 1 ...

... But then I'm not a tax expert and I sometimes don't understand the nuances that tax professionals are trained in.

CRA IT-533 Bulletin - Interest Deductibility and Related Issues defines interest as having to meet three criteria.

1. The amount must be calculated on a day-to-day accrual basis.
2. The amount must be calculated on a principal sum.
3. The amount must be compensation for the use of the principal sum.

I am going to be honest here. I tried to read the bulletin but my eyes started to glaze over and I began sighing .. a lot.! LOL Reading tax bulletins is not one of my favorite things to do. So I can't quote you exactly where it says this ... but I will rely on Eileen's superb skills in this department.

She says the mortgage interest is only claimable on the original mortgage ... so if you refinanced to consolidate your debts and credit card balances ... when calculating your home office expense deduction, you must prorate your total interest expenses to reflect only the interest pertaining to your original mortgage.

However, Stephen Thompson in 167 Tax Tips for Canadian Small Business 2009 explains that if you increase your mortgage to finance the start-up of your business (as opposed to personal debt described above), the portion of the mortgage interest that relates to the business is 100% deductible as a business expense.

You must only include expenses that relate to the whole house or your home office in particular. Costs related solely to personal use areas are to be excluded ... this means you CANNOT just take a percentage of the total home maintenance costs.

If you are operating your business from your home, be sure your policy includes coverage for operating a business from your home. You would hate to invalidate a policy just because you didn't know any better. This additional coverage is 100% deductible under your regular business expenses, not as part of the home office expenses.

Any expense related to separate coverages listed in your policy for personal property items should NOT be included in the proration of your home insurance for this calculation.

Home Offices in B.C. ... and HST

If you have your home office in B. C. you do NOT qualify for the HST Residential Energy Credit ... think BC Hydro and Terasen Gas. You do however qualify for the Residential Energy Rebate. Find out more about what YOU need to do in my article on HST Transitioning.

Bookkeeping Forum Discussions on Home Office Expenses

You can find more information on home office expense in The Bookkeeping Forum.

1. Home office expenses for employees is discussed in Business Use of Home.
2. Claiming home office expenses if you run an incorporated home based business is discussed in Work Space in Home.
3. Will claiming this tax deduction create a capital gain when you sell your home? was discussed in Home Office Expense Deduction.
4. Why won't the tax program let me claim home office expenses? was discussed in Home Office Expenses Cannot Create a Loss.

That's it for now. When doing tax preparation for your home business, take advantage of the tax saving opportunity to claim your home office expenses ... because every little bit counts when it comes to legally reducing your overall tax bill.

Remember this article just presents information to you and should not be construed as advice. When in doubt, ask a professional accountant for advice specific to your circumstances.

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