Self-employed taxpayers are defined as people who work full-time in their own business and also those who run a business in addition to employment. If they use a designated space at home exclusively for business on a regular basis, they may qualify for the Home Office Expense Deduction.
For the self-employed, the Home Office Expense Deduction allows certain “above the line” deductions that ordinarily would be considered personal and unallowable. These include both direct and indirect expenses.
Examples of direct expenses include: costs of repairing the home office and upgrades, depreciation of the furniture and fixtures used in the home office, a phone line/Internet connection that is used exclusively in the home office, office supplies and other items related to the home office.
Examples of indirect expenses include: a share of utility costs, depreciation of house, insurance, mortgage interest expense and real estate taxes. For example, if 25 percent of the home’s square footage is used as a home office, 25 percent of the utility costs could potentially be included in the home office deduction.
Another benefit of qualifying for a home office deduction is the ability to deduct additional transportation costs. Generally, expenses incurred for transportation between a taxpayer’s home and regular place of business (commuting) are personal, nondeductible expenses. However, when a taxpayer’s home office qualifies as the principal place of business, it is possible to deduct all daily transportation costs between the residence and other work locations in the same trade or business. This applies regardless of whether the other work location is regular or temporary and regardless of the distance.
If the person working from home is categorized as an employee of another taxpayer (for example, telecommuters), the business use of the home must be for the convenience of the employer. As a practical matter, if the employee also has an office furnished by the employer, it is unlikely that working at home is for the employer’s convenience.
If qualifying, potential deductions would be considered “below the line” and would be added to other miscellaneous itemized deductions to see if the total was at least 2 percent of adjustable gross income (AGI).? If the home office deduction together with other miscellaneous itemized deductions exceed 2 percent of AGI, the amount in excess of 2 percent of AGI is deductible.
Whether a person is self-employed or an employee, a home office does not have to be a separate room in the home to qualify. A room or a separately identifiable area can serve as a home office. To qualify as having a home office used exclusively for business on a regular basis, the taxpayer must meet one of three tests:
? The home office is the principal place of business. One of two requirements must be met to satisfy the principal place of business definition, either the “management and administrative activities” test or the “relative importance/time” test. If the “management and administrative activities” of the taxpayer’s business are performed in the home office, and there is no other place where the taxpayer conducts these activities, it is considered your principal place of business. The “relative importance/time” test focuses on the time spent at each place of business. If the home office is where business is conducted most, it is considered the principal place of business.
? The home office is used for meeting patients, clients or customers. This is straightforward. The only requirement is that the patient, client or customer must be physically present in the home office.
? The home office is a separate structure. This is for a home office that is located in a separate, unattached structure on the same property as the taxpayer’s home (for example a studio, workshop or unattached garage.)
In addition, if the taxpayer is in the business of selling products at retail or wholesale and the taxpayer’s home is the sole fixed business location, home expenses allowable to the space that is used to store inventory can be included in the home office deduction calculation. It is important to note here that while the storage space must be used regularly to qualify for the deduction, the space does NOT have to be used exclusively for business (such as a garage, closet or shed).
The advantages of claiming a Home Office Expense Deduction must be weighed against the disadvantages. One possible disadvantage is that the taxpayer would recognize gain on the sale of a home to the extent of any depreciation allowable as a home office after May 6, 1997.
In addition, returns claiming a home office deduction may face additional scrutiny from the IRS.
Due to the number of business owners, contractors and employees who now do a majority of their work from home, it’s a good idea to consult with your CPA or tax adviser on the advantages and limitations of the Home Office Expense Deduction. Find out how this deduction or other options might support your individual income tax situation.