Home-office deductions can mount up, providing ample tax savings. If you’re self-employed, those deductions may well be available. The same is true if you run a sideline business from home.
You may even qualify for these deductions as an employee, although that’s more difficult than it is for self-employed individuals.
Required: There are three ways to get home-office deductions. Of the three, the most common is to assert that an area of your home is your “principal place of business.”
There are two other ways to qualify for home-office deductions…
Meeting place. Even if your home is not your principal place of business, you can claim a home-office deduction if you meet with clients or customers in one area of your house regularly, not occasionally, and in the normal course of your trade or business.
Whether such meetings are “occasional” or “regular” will be determined on a case-by-case basis, in the event that the IRS questions home-office deductions. Regular meetings deliver deductions… occasional meetings don’t.
Separate structure. Rather than use an area within the confines of your living space, you might use a separate structure — such as a detached garage — as your home office and claim a deduction.
Most people who work at home won’t pass the meeting place or separate structure tests, so they must be able to rely upon the “principal place of business” requirement to qualify for home-office deductions.
Your principal place of business can be the location where the most important activities of that business are performed. You can qualify a home office as your principal place of business if that’s where you regularly and exclusively perform administrative and management tasks for that business (see below).
In addition, there can be no other place where you perform substantial administrative or management activities.
Example: John Smith is a self-employed consultant. He spends most of his working hours at clients’ offices, meeting with the employees of those clients. John keeps a room in his home as an office, where he writes reports, sends out bills, etc.
Result: John may be able to take tax deductions for a home office.
Loophole: John can take a home-office deduction even if he maintains an office outside of his home where he meets with prospects and makes presentations to clients.
As long as John does substantially all of the administrative and management work from his home office, that will be his principal place of business.
Strategy: If you have both a home office and another place where you do business, shift administration and management to the home office. This will increase your tax deductions.
Included: Administration and management activities are spelled out in IRS Publication 587, Business Use Of Your Home. They include…
Sending out bills.
Keeping books and records.
Storage of inventory/supplies.
Setting up appointments.
Writing reports, such as sales reports and financial reports.
A MATTER OF TIME
In some cases, it’s not possible to say where administrative and management activities are done.
Example: A concert musician practices at home for performances. He does little administration or management related to his occupation.
Is his principal place of business his home or the concert hall?
Determination: Such scenarios may be decided by the amount of time spent in each location. In one real case that went to tax court, a musician spent much more time practicing at home than performing at the concert hall. Therefore, the court decided that the musician could take home-office deductions (Popov, Ninth Circuit, 2001).
Strategy: If there is no clear-cut answer as to where administration and management are performed, try to spend more work time in your home office than anywhere else.
If you work at home but as an employee (rather than someone who is self-employed), you still have to meet the requirements for a principal place of business, as described above, to take a home-office deduction.
Additional requirement: Your home office is a principal place of business only if it’s used as such “for the convenience of the employer.”
What this means: If your employer provides you with office space and does not require you to work at home, you probably will not be able to say that your home office is your principal place of business, no matter how much time you spend there or how much work you do there. To pass the “convenience of the employer” test…
Your employer must not provide you with an office and…
Your employer must require you to do administrative/management tasks at home.
ALL WORK AND NO PLAY
If you can say that your home office is your principal place of business, you’re halfway along the path to valid home-office tax deductions. The same is true if you regularly use part of your home for business meetings or if you do business in a separate structure there.
Regular and exclusive: The second half of the home office test is that you must have an area of your home that’s used regularly and exclusively for your business. Once a year isn’t enough to constitute regular use. Every day is. If it’s once a week, you have a better chance than if it’s once a month.
Trap: Not proving that you use it enough.
Strategy 1: Keep records of your use there. If you work on a computer, for example, save your work every time you use your home office to show regular use.
Strategy 2: If you have a room that’s used for a home office, avoid using it as a guest bedroom, say, or as a place for watching TV.
Minimal other use of a home office won’t ruin a deduction. You can check personal E-mail there or keep a tennis racket in the closet.
Loophole: A home office need not be a separate room. It can be part of a room, as long as the area is used only for business.
Once you’re eligible, there are two ways to calculate a home-office deduction…
By room. Say you have a house with eight rooms of roughly the same size. One is used as a home office.
You would be able to deduct one-eighth (12.5%) of your household expenses. You could deduct 12.5% of your homeowner’s insurance premiums, 12.5% of your heating oil bills, and so on.
You also can depreciate 12.5% of your basis in the house (not including the value of the land).
To figure your depreciation deduction…
Determine your basis in the property (what you paid for it plus improvements).
Subtract an allocation for land. Your property tax assessment can give you the percentage.
The result is your basis (tax cost) in your house. If your property is worth $500,000 and 20% of the value is land, the house has a basis of $400,000. However, use current value, if lower than basis.
Depreciate the home-office portion of the house. If that’s 12.5%, and basis is $400,000, you have $50,000 worth of house to depreciate. You do not need to redetermine this amount each year. You’ll generally take that $50,000 of deductions over a 39-year schedule.
By square foot. Say your home has 2,000 square feet of living space. You keep a 10-foot-by-10-foot area as a home office.
Your 100-square-foot office comprises 5% of your home, so you can take 5% deductions.
You can choose either the room or the square-foot method, whichever gives you the best result.
Trap: Be prepared to show how you arrived at your home-office percentage. If you use square footage, have the numbers ready.
Self-employed individuals must use Form 8829, Expenses for Business Use of Your Home, to calculate home-office deductions and report the result on Schedule C of Form 1040. Employees who qualify can take the write-off on Schedule A, as a miscellaneous itemized deduction subject to the 2% of adjusted gross income floor and use a worksheet in Publication 587, Business Use of Your Home.
LEARNING THE LIMITS
Two traps to be aware of if you want to take a home-office deduction…
You can’t deduct more than your gross revenues minus the deductions otherwise allowable for any home owner (e.g., taxes and mortgage interest) and minus allowable business deductions (supplies, etc.) for the business you conduct in your home office. See Publication 587 for details.
Any depreciation deductions you take will be taxed when you sell your home. If you have taken $10,000 in cumulative depreciation deductions, for example, you’ll pick up $10,000 in taxable income when you sell.
Fortunately, that income generally will be taxed at 25%. Thus, you might be taking years of deductions at tax rates up to 35%, and then pay the deferred tax at only 25% — a very worthwhile trade-off.