By David M. Kendrick, CPA, MST
It never ceases to amaze me when I ask a client whether or not they have a home office and they respond with something along the lines of, “Why yes I do, but I don’t want to claim it because I don’t want the IRS audit me” -or- “I don’t qualify because I don’t own a home” –or- the overtly overused, “I don’t want to raise any red flags”.
Why all the concern? The home office deduction became controversial in the aftermath of the 1993 Supreme courts Soliman decision where it decided that in order to qualify for the deduction, the taxpayer’s home office had to be the “principal” place of business. Their test was primarily based on the importance the home office plays in a taxpayer’s business (both in activities and time spent). Since Dr. Soliman, (an anesthesiologist) wasn’t administering anesthesia (his primary work function) from his home, he lost his case putting the brakes on many home office deductions for the self-employed since most couldn’t meet this hurdle. Then, after nearly a decade, the IRS finally loosened the reigns and left us with a new test.
News flash – The deduction for the use of an office in your home (whether you own your home or rent) is a legitimate, above board, and one you are entitled to if you meet the tests!
<?>The home office must be used in a trade or business activity
There isn’t a deduction unless your activity rises to the level of a trade or business. The home office deduction isn’t available as an investment expense or hobby.
<?>The home office must be used regularly and exclusively for business, the “use” test
In terms of your home office, regular means on a continuous, ongoing basis and exclusively means business use only. Any personal use of the space, no matter how small, may lead to failure of this test (there are exceptions namely the storage of inventory or product, use as a daycare facility or de-minimis non-business use)
<?>And the home office must be one of the following…
Your principal place of business – again, your home office must be used regularly and exclusively for administrative or management activities and you don’t have any other fixed location for you to conduct these activities (not counting incidental activities performed outside of the home).
A place to meet with patients, clients or customers in the normal course of your business – Again, the use has to be on a regular basis, using your home for occasional meetings and telephone calls is insufficient.
A separate structure not attached to the dwelling unit used for trade or business purposes - If the space meets the “use “ tests the structure does not have to be your principal place of business or a place where you meet patients, clients or customers.
Special rule for employees
If you are deducting as an employee, the use of your home office must be for the convenience of your employer. If the employer does not require the employee to work from home and provides an office or work space, a home office is likely to be considered for your convenience and therefore not deductible. Also, as an employee, you cannot rent any part of your home to your employer and use the rented portion to perform services as an employee for that employer.
Special rule for depreciation
When you sell your home, you will not be able to exclude the part of any gain (if applicable) equal to any depreciation after May 6, 1997 associated with your home office.
Benefits & Limits regarding the deduction
Certain itemized deductions such as qualified mortgage interest and real estate taxes are fully deductible even if the home isn’t used for business. However, when factored in the calculation for the home office deduction, they reduce self employed income and may produce a net loss deduction which is usually a more favorable tax result.
Other home office expenses (utilities, insurance, maintenance etc) are deductible only to the extent of net business income (gross business income after being reduced by other allowable business expenses such as supplies, advertising, automobile expenses etc). Any home office expenses that are not deductible due to this income limitation may be carried forward and utilized in future years.
This is a brief summary of the home office deduction. Let us know if we can assist you in determining your eligibility for this deduction to reduce your tax bill! A properly prepared home office deduction is unlikely to bring additional scrutiny to your tax return.