What Is an Occupancy Expense for Tax Purposes?
Gain clarity on the rules for claiming business space costs as a tax deduction. Learn how to correctly allocate and substantiate your expenses for compliance.
Occupancy expenses are the costs of maintaining and using a physical space for business activities. These expenditures are a component of a company’s operating costs that directly impact profitability. Proper identification and allocation of these expenses are also part of tax planning.
Identifying Common Occupancy Expenses
A primary occupancy expense for many businesses is the cost of rent or lease payments. For businesses that own their property, the equivalent cost is mortgage interest, but only the interest portion is an expense for tax purposes. Property taxes on the business premises are another occupancy cost.
Utilities are a category of occupancy expenses that include electricity, natural gas, water, sewer services, and trash collection fees.
Property insurance covers the business against losses from events like fire or theft to the physical structure and includes general liability insurance for the premises. The costs of general repairs and maintenance necessary to keep the property in a usable condition are also occupancy expenses.
Calculating the Business Portion of Occupancy Expenses
The home office deduction is available to self-employed individuals, independent contractors, and gig economy workers; it is not available to employees. When a business operates out of a space that is also used for personal purposes, it is necessary to allocate expenses between business and personal use. Direct expenses are costs that apply only to the business portion of the space, such as painting or repairs for a dedicated home office, and are fully deductible. Indirect expenses are costs that benefit the entire property, including mortgage interest, property taxes, and utilities, which must be divided.
The most common method for allocating indirect expenses is the square footage method. To calculate this, you must measure the total square footage of your home and the square footage of the area used exclusively for business. Dividing the business area’s square footage by the total home square footage yields the business-use percentage.
For a practical example, consider a home that is 2,000 square feet in total. Within this home, a room used exclusively as an office measures 200 square feet. The business-use percentage would be 10% (200 sq. ft. / 2,000 sq. ft.). If the homeowner incurred $10,000 in mortgage interest, $4,000 in property taxes, and $2,000 in utilities for the year, the total indirect expenses would be $16,000. By applying the 10% business-use factor, the deductible occupancy expense would be $1,600.
As an alternative to calculating actual expenses, the IRS offers a simplified option. This method allows for a standard deduction of $5 per square foot of the home used for business, up to a maximum of 300 square feet. This results in a maximum deduction of $1,500. Taxpayers who choose the simplified option cannot depreciate the business portion of their home or deduct actual expenses.
The exclusive-use test means the specific area of the home must be used only for trade or business activities. The regular-use test means the space is used on an ongoing basis for business.
Reporting Occupancy Expenses on Tax Returns
For sole proprietors and single-member LLCs who file taxes as individuals, occupancy expenses related to a home office are reported using Form 8829, Expenses for Business Use of Your Home. The final deductible amount calculated on Form 8829 is then transferred to Schedule C (Form 1040), Profit or Loss from Business, where it is subtracted from business income.
Corporations and multi-member partnerships handle occupancy expenses differently. If the business owns or rents a commercial property, the full amount of rent, utilities, and other related costs are recorded as business expenses on the appropriate tax return, such as Form 1120 for corporations.
When a shareholder or employee of a corporation uses part of their home for business, the corporation can deduct these costs only by reimbursing the individual through an accountable plan. For a reimbursement plan to be considered accountable, it must meet three IRS requirements: the expenses must have a clear business connection, they must be properly substantiated by the employee, and any excess reimbursement must be returned in a timely manner. The corporation then deducts the reimbursed amount as a business expense.
Required Documentation and Record-Keeping
To substantiate deductions for occupancy expenses, taxpayers must maintain all documents that prove the amounts claimed. For homeowners, this includes mortgage interest statements (Form 1098), property tax bills, and homeowners’ insurance statements. Renters should keep a copy of their lease agreement and records of all rent payments.
Utility bills for electricity, gas, water, and internet should be saved for the entire year to accurately total the annual costs. Receipts and invoices for any repairs or maintenance performed on the property must be kept, with notes indicating whether the repair was for the entire home (indirect) or specifically for the business-use area (direct).
A record of the home office’s square footage calculation is also needed. This can be a simple floor plan of the home with the dimensions of the total living area and the dedicated business space clearly marked. This document provides the basis for the business-use percentage.