Because Charlotte uses the office exclusively and on a regular basis as a principal place of business, she is allowed to deduct the costs associated with the home office.  However, the home office deduction cannot exceed her income from the trade or business less the costs unrelated to the office.  In this case, she is limited to a maximum home office deduction of $3,000 ($37,000  –  $25,900  –  $8,100).

The costs of the home office must be allocated on some reasonable basis. The square footage of the office is 25% (500  ÷  2,000) of the total square footage and provides a reasonable basis to allocate expenses that are related to the house.

Total home office costs are limited to            $ 3,000

Home mortgage interest  ($6,400  x  25%)                  (1,600)

Real property taxes  ($2,100  x  25%)                            (525)

Balance of income                                                    $    875

Insurance   ($560  x  25%)                                             (140)

Utilities  ($800  x  25%)                                                  (200)

Repairs and maintenance  ($600  x  25%)                      (150)

House cleaning  ($960  x  25%)                                      (240)

Balance of income                                                    $    145

Depreciation ($5,000  x  25%  = 1,250)                           (145)

Total home office costs                                           $     -0-

Charlotte has no income from her custom publishing business.  She can deduct only $3,000 of the $4,105 of home office expenses because home office expenses cannot create a business loss.  She must deduct the expenses related to interest and taxes first, then deduct her other business expenses, then depreciation.  She may carry forward the $1,105 ($145 limit  –  $1,250 current depreciation) not used in the current year to a future year when her business income can absorb the deduction.