If you qualify to deduct home-office expenses, the IRS will help pay bills that are normally considered personal. These include part of what you pay to light and heat your home, a share of the rent if you are a tenant or depreciation on your house if you own it, a portion of your homeowners insurance and part of your maintenance and repair expenses. Yes, the rules are strict, but Congress has relaxed them a bit in recent years.
Although home-office deductions are open to both employees and self-employed taxpayers, as a practical matter it’s almost impossible for employees to qualify. In addition to meeting all the other tests discussed below, for an employee to claim these tax-savers, the office has to be maintained for the convenience of the employer. Basically, that means you have to be required to work at home, not just choose to do so. Furthermore, employees who do qualify for home-office deductions must claim them as miscellaneous deductions, which means you get a tax benefit only to the extent the qualifying expenses — and all your other miscellaneous deductions — exceed 2% of your AGI.
If you have a sideline business in addition to your job and run your business out of your home, you aren’t tripped up by the convenience-of-your-employer test. This type of moonlighting is, in fact, the basis of many home-office deductions.
The biggest roadblock to qualifying for these deductions is that you must use a portion of your home exclusively and regularly for your business. The office is generally in a separate room or group of rooms, but it can be a section of a room if the division is clear – thanks to a partition, perhaps – and you can show that personal activities are excluded from the business section.
The law is clear and the IRS is serious about the exclusive-use requirement. Say you set aside a room in your home for a full-time business and you work in it at least ten hours a day, seven days a week. Let your children use the office to do their homework, though, and you violate the exclusive-use requirement and forfeit the chance for home-office deductions.
The rule doesn’t mean you’re forbidden to make a personal phone call from the office or that you have to rush outside whenever a family member needs a moment of your time. Although individual IRS auditors may be more or less strict on this point, some advisors say you meet the spirit of the exclusive-use test as long as personal activities invade the home office no more than they would be permitted at an office building. (Two exceptions to the exclusive-use test are discussed later.)
There’s no arbitrary definition of what constitutes regular use. Clearly, if you use an otherwise empty room only occasionally and its use is incidental to your business, you’d fail this test. But if you work in the home office a few hours or so each day, you’d probably pass. This test is applied to the facts and circumstances of each case that is challenged by the IRS.
In addition to passing the exclusive- and regular-use tests, your home office must be either the principal location of that business or a place where you regularly meet with customers or clients. If you are an employee and have a part-time business based in your home, you can pass this test even if you spend much more time at the office where you work as an employee.
There is, though, the question of what constitutes a business. Making money from your efforts is a prerequisite, but for purposes of this tax break, profit alone isn’t necessarily enough. If you use your den solely to take care of your personal investment portfolio, you can’t claim home-office deductions because your activities as an investor don’t qualify as a business.
Taxpayers who use a home office exclusively to actively manage several rental properties they own, though, may qualify for home-office tax status – as property managers rather than investors. As with the regular-use test, whether your endeavors qualify as a business depends on the circumstances. The more substantial the activities, in terms of time and effort invested and income generated, the more likely you’ll pass this test.
What if your business has just one office – in your home – but you do most of your work elsewhere? First, remember that the requirement is that the office be the principal place of business, not your principal office. In an important Supreme Court case a few years ago, a doctor lost his attempt to claim home-office expenses even though his home office was his only office. The court denied the write-offs because it said his principal place of business was the hospital where he cared for patients.
Congress basically has overturned that ruling, though, so you can pass the principal place of business test even if you spend most of your time elsewhere, as long as you manage the business from the home office and you don’t have another office for the business elsewhere. This helps salespeople, who spend most of the workday at customers’ offices, for example, and consultants, housepainters and other trades people who spend most of their time at job sites away from home.
If you can't pass the liberalized test, you can still qualify for home-office deductions if you regularly meet with customers, patients or clients in the business part of your house. This provision can prove helpful, for example, to doctors, accountants and salespeople who have a business location elsewhere but maintain a home office for meeting with clients in the evenings or on weekends. Such at-home dealings must be an important, rather than an incidental, part of the business.
If your home office is in a separate, unattached structure – a loft over a detached garage, for example – you don’t have to meet the principal-place-of-business or the deal-with-customers test. As long as you pass the exclusive- and regular-use tests, you can qualify for home-business write-offs.
The exclusive-use test does not apply if you use part of your house to provide day-care services for children, the elderly or handicapped individuals. If you care for children in your home between 7 a.m. and 6 p.m. each day, for example, you can use that part of the house for personal activities the rest of the time and still claim business deductions. To qualify for the tax break, your day-care business must meet any applicable state and local licensing requirements.
Another exception to the exclusive-use test applies to a portion of your home used to store product samples or inventory you sell in your business. Assume your home-based business is the retail sale of home-cleaning products and that you regularly use half of your basement to store inventory. Occasionally using that part of the basement to store personal items would not cancel your home-office deduction. To qualify for this exception, your home must be the only location of your business.
Your business deductions are based on the percentage of your home used for the business. The most exact way to figure this proportion is to measure the square footage devoted to your home office and find what percentage it is of the total area of your home. If the office measures 150 square feet, for example, and the total area of the house is 1,200 square feet, your business percentage would be 12.5% (150 ÷ 1,200).
An easier way is acceptable if the rooms in your home are all about the same size. In that case, you can figure the business percentage by dividing the number of rooms used in your business by the total number of rooms in the house.
Special rules apply if you qualify for home-office deductions under the day-care exception to the exclusive-use test. Your business-use percentage must be discounted because the space is available for personal use part of the time. To do that, you compare the number of hours the day-care business is operated, including preparation and clean-up time, to the total number of hours in the year (8,760).
Assume you use 40% of your house for a day-care business that operates 12 hours a day, five days a week for 50 weeks of the year. That’s 3,000 hours out of the total of 8,760 hours in the year. That’s 34% of the available hours, so your business write-off percentage is 13.6% (40% of 34%).
This is a complicated area, but the tax savings can be well worth the hassles. Here’s what you can write off.
Money spent to repair or maintain the business space is deductible. If you paint the room that is your home office, for example, the entire cost can be deducted.
These will probably be your most fruitful home-office deductions. Because part of your home qualifies as business property, part of the costs of running it can be converted from nondeductible personal expenses to business write-offs. If your office space takes up 20% of the house, you can deduct 20% of your utility bills, home insurance bills and overall home repairs and maintenance costs. (In a nickel-and-dime crackdown, Congress says no part of the cost of the first telephone line in your home can be deducted. The full cost of a special line for your business and other direct expenses – such as the cost of long-distance calls – can be written off.)
Mortgage interest and property taxes are deductible expenses whether you qualify for home-office deductions. But with a home office you convert part of those expenses from personal itemized deductions to business write-offs. Because business expenses reduce self-employment income, they can also trim what you owe in social security taxes. For 2006, the self-employment tax claims 15.3% of the first $94,200 of self-employment and wage income. Every $1,000 of mortgage interest and property-tax expense you shift to the category of business deductions can save $153 in self-employment tax. (We estimate that the 15.3% levy will hit about the first $98,400 of earnings in 2007.)
If you rent the home where your office is located, this computation is easy: You deduct the same percentage of your rent as the percentage of your home devoted to your business. If you own your home, you depreciate the business part of the house.
Commercial real estate – which is how that part of your home is categorized – put in service on or after May 13, 1993 is depreciated over 39 years, so a full year’s depreciation would be 2.56% of the value of the business area.
If you put your home office into service between January 1, 1987, and May 12, 1993, the depreciation stretches over 31.5 years, so a full year’s depreciation would be just 3.17% of the business area.
If you established your home office before January 1, 1987, you continue to base your write-offs on the speedier schedule in effect at that time.
The first step in determining your depreciation deduction is to know the tax basis of your house. That’s basically what you paid for the place, plus the cost of any improvements. You depreciate only the cost of the house, not the land, so you must make allowances for the value of your lot.
Assume your depreciable basis is $100,000 and you used 20% of the house all year for your home business. If your home office was put into service on or after May 13, 1993, your depreciation would be 20% of 2.56% of $100,000, or $512.
Although that may seem like a lot of work for a rather piddling deduction, remember that you exert most of the effort only once, when you set up your depreciation schedule, but get to claim the depreciation write-off year after year as long as you have the home office. Also, as with other home-office deductions, depreciation trims not only your income tax bill but may also limit the amount of social security tax owed on your self-employment income.
You can also claim depreciation deductions on furniture and equipment used in your business, as discussed later. You earn those write-offs whether or not you pass the home-office tests.
The law puts a cap on how much you can deduct for the business use of the home. Basically, your home-office deductions can’t exceed your home-based business income. In other words, home-office expenses can’t create a tax loss to shelter other income. There are even rules on the order in which you should deduct expenses from your business income.
You first deduct the business portion of your mortgage interest and property taxes, for example. Then come expenses such as the cost of secretarial help and office equipment and supplies. Those costs could be deducted whether or not you qualify for home-office deductions. By making you deduct them first, this rule reduces the amount of business income left over to be offset by home-office expenses such as utility bills. The last thing you deduct is depreciation.
Until 2003, claiming home office deductions had the potential of backfiring when you sold the house.
Remember, profit from the sale of a home is tax-free in almost all situations. But there used to be a catch if you claim home-office deductions: The part of your home that was considered a business property for home-office deduction purposes was not part of your home when it came to figuring tax-free profit. If you claimed 10% of your home was a home office, for example, 10% of your profit wouldn’t be tax-free. That could be particularly painful if you have built up profit over decades but only used part of the house as an office during the last few years before you sell.
But in 2003, IRS had a change of heart. It ruled that even if you had a business in your home, the entire profit could be tax free if you otherwise qualified under the ownership and use rules. Actually, not quite all the profit would be tax-free, though. Any profit attributable to depreciation claimed for a home office after May 6, 1997, is taxed at 25% (unless you’re in the 10% or 15% bracket, in which case, that rate would apply). If you claimed $5,000 of depreciation between May 7 and the time you stopped using the home office, for example, $5,000 of your profit would be taxed at 25%. Still, the new change is a big break for taxpayers with offices in their homes.
Employees claim home-office expenses as miscellaneous itemized deductions on Schedule A. Self-employed taxpayers use a special form that the IRS figures will take a little over an hour to complete. If that sounds ominous, you’re correct in thinking the IRS takes a hard look at home-office deductions. You have to be prepared to back up your deductions if challenged.
Many taxpayers think claiming home-office deductions is like buying a ticket for a tax audit. That’s not true, but you do need to keep careful records to prove your write-offs are legitimate. Photographs of the office will be helpful. Take pictures showing the desk, file cabinets, typewriter and other business equipment. Keep a sketch of your home to back up calculations of the business percentage of total space. Have your home address and the number of your home-office phone printed on business cards and stationery. Keep a running log that shows when you use the office, what you work on and with whom you meet. This doesn’t have to be fancy; notes on a desk calendar will do.