The tax break has been expanded, but make sure you know the rules.
The Taxpayer Relief Act of 1997 included a modification of the IRS’s definition of “principal place of business” that will permit a larger number of taxpayers to qualify for the home-office deduction. For tax years beginning after 1998, the deduction will be available for home offices that are used for administrative or management activities related to the taxpayer’s business (for example, billing, maintaining records, ordering supplies, scheduling appointments, creating reports).
Business/Personal Boundaries Home-based businesses, by their very nature, often have less structure. While many consider this to be an advantage, working at home can be a double-edged sword. The lack of structure tends to result in home-based workers putting in more hours than when they did not work at home. Having set office hours and “closing up” at the end of the day will help you balance business and personal matters.
Under the amended rules, a taxpayer is allowed to deduct expenses of a home office that is used for business purposes only if the space is used “exclusively” on a “regular basis” as:
The principal place of business carried on by the taxpayer,
- A place for meeting with clients or customers in the ordinary course of business, or
- A place for the taxpayer to perform administrative or management activities associated with the business, provided there is no other fixed location from which the taxpayer conducts a substantial amount of such administrative or management activities.
The Taxpayer Relief Act of 1997 added this third provision to the definition of principal place of business.
The exclusive-use test will be satisfied if a specific portion of the taxpayer’s home is used solely for business purposes or inventory storage. The regular-basis test is satisfied if the space is used on a continuing basis for business purposes (that is, incidental business use will not qualify.)
In determining the principal place of business (first provision under the definition of principal place of business, above), the IRS considers two factors: Does the taxpayer spend more business-related time in the home office than anywhere else? Are the most significant revenue-generating activities performed in the home office? Both of these factors must be considered when determining the principal place of business.
Employees
To qualify for the home-office deduction, an employee must satisfy two additional criteria. First, the use of the home office must be for the convenience of the employer (for example, the employer does not provide a space for the employee to do his/her job). Second, the taxpayer does not rent all or part of the home to the employer. Employees who telecommute may be able to satisfy the requirements for the home-office deduction.
Expenses
Home office expenses are classified into three categories:
Direct Business Expenses relate only to the taxpayer’s business activity (for example, supplies, salaries). Expenditures for additional phone lines, long-distance calls, and optional phone services for the business may be deductible as direct business expenses. However, basic local telephone service charges (that is, monthly access charges) for the first phone line in the residence generally do not qualify for the deduction.
Permissible Expenses are expenditures that could be included as itemized deductions in the individual’s tax return (for example, mortgage interest, real estate taxes, and casualty losses).
Previously Non-deductible Expenses would not be deductible if not for the home office deduction (for example, insurance, utilities, and depreciation).
Limitation
Home office deductions are limited to the gross income from the business activity. Previously non-deductible expenses cannot create or increase a net loss from a business activity. However, a carryover to future years is available for unused, allowable home-office expenses.
Sale of Residence
Tax rules generally permit a $500,000 (married filing jointly) or $250,000 (single or married filing separately) exclusion on the gain from the sale of a primary residence. If part of the home is used for business purposes, the gain is divided into two parts — personal-use portion (the exclusion applies) and business-use portion (exclusion does not apply). For example, a taxpayer who qualifies for the exclusion, but has used 25 percent of the home for business purposes during the during past five years, will only be able to apply the exclusion against 75 percent of any gain recognized on the sale of the home.
As with many tax laws there are exceptions to this rule. If you’d like a clearer picture of the size of the exclusion you qualify for, please call us.
Taxes
The “office-in-home” tax deduction is valuable because it converts a portion of otherwise nondeductible expenses (for example, utilities and homeowners insurance) into a deduction. The treatment of home offices for income tax purposes is one of the more controversial provisions in the tax law.
An individual is not entitled to deduct any expenses of using his/her home for business purposes unless the space is used exclusively on a regular basis as the “principal place of business.” The IRS applies a 2-part test to determine if the home office is the principal place of business.
Do you spend more business-related time in your home office than anywhere else?
Are the most significant revenue-generating activities performed in your home office?
If the answer to either of these questions is no, the home office will not be considered the principal place of business, and the deduction will not be available.
Business use of the home by an employee must also be for the convenience of the employer. These rules make it very difficult for an employee to qualify for the deduction.
If these three tests are met, the deduction is limited to the gross income from the business activity. Furthermore, a deduction for home-office expenses cannot create or increase a net loss from the business. Any disallowed deduction may be carried over to future years.
Taxpayers taking a deduction for business use of their home must complete Form 8829. Some tax experts believe that taking a deduction for home-office expenses, whether clearly allowable or not, increases the likelihood of an IRS audit.
These are some thoughts to consider.
If you have a home office or are considering one, please contact me. This is a specialty of mine.
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