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What
You Need To Know About the Home Office Deduction
© 2003 by Lynne
Ganoe
The
home office deduction is a great little perk to the home-based
business owner. Being
able to write off a portion of your personal expenses not only
reduces the income tax that you owe, but also reduces
self-employment taxes. But
it's important to know the rules to be sure that you qualify,
and to keep good records to back up your deductions.
Here's a rundown of what you need to know if you are
planning to take the home office deduction.
Qualifying
for the Home Office Deduction
First
you need to make sure that you qualify. Your home office
may be in any type of residence such as a house, apartment,
condominium, mobile home, or boat. You do not need to own your
home in order to claim an "office in the home"
deduction. Also, the area does not necessarily need to be
located IN your home; for instance, a garage or other separate
structure can be considered when determining whether you qualify
for the deduction.
To
qualify for a home office deduction, you must use an area of
your home regularly and exclusively for business
purposes and you must meet at least one of these
conditions:
-
You
use the space as your principal place of business, and the
business generates revenue. Under recent changes in the law,
you can meet this qualification even if you only perform
administrative and managerial functions there and if
you have no other fixed principal place of business.
-
You
use the space to meet with clients, patients or customers.
-
You
use the area exclusively to store inventory or product
samples for your wholesale or retail business.
Exclusive
Use
Remember
that your home office must be used solely for business purposes.
If you also use your home office to watch TV or build model
airplanes, you can't claim the home office deduction.
Exceptions
to Exclusive Use
You
do not have to meet the exclusive use test if either of the
following applies:
Storage of
inventory or product samples. If you use part of your home
for the storage of inventory or product samples, you can claim
expenses for the business use of your home without meeting the
exclusive use test. However, you must meet all of the following
tests:
-
You
sell products at wholesale or retail as your trade or
business.
-
You
keep the inventory or product samples in your home for use
in your trade or business.
-
Your
home is the only fixed location of your trade or
business.
-
You
use the storage space on a regular basis.
-
The
space you use is an identifiably separate space suitable for
storage.
Example:
Your home is the sole fixed location of your business of selling
hand-made soaps. You regularly use half of your basement for storage of
inventory and product samples. You sometimes use the area for
personal purposes. The expenses for the storage space are
deductible even though you do not use this part of your basement
exclusively for business.
Rule
for 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.
Figuring
the Percentage
You
can use any reasonable method to determine what percentage of
your home is used for business, but the following are two common
ways to come up with the business use percentage:
-
Divide
the area (width multiplied by length) of the portion of your
home used for business by the total area of your home.
For example, if your home office is 10 feet by 15 feet, the
total area of your office is 150 square feet (10 x 15 =
150). If the total square footage of your home is
1,300 sq. feet, then you would divide 150 by 1300, resulting
in a percentage of 12% (150 / 1300 = .12).
-
If
you use one room of your home for business and all the rooms
in your home are approximately the same size, you can just
divide 1 by the total number of rooms in your home.
For instance, if you have a 5-room house and you use one
room for business, 1 / 5 = .20, or 20%.
Whatever
percentage you come up with is what you would multiply your
qualified indirect expenses by to determine the deductible
amount.
What
is Deductible?
Home office
expenses are divided into two categories: Direct and Indirect
costs.
Direct
costs are expenses only for the business portion of your
home, such as painting and repairs only in the area used for
business. These costs are deductible in full.
Indirect
costs are those costs
associated with keeping and running your entire home such as
insurance, utilities, and general repairs. These costs are
deductible based on the percentage of your home used for
business.
Unrelated
costs are expenses related only to
the part of your home not used for business (such as lawn care
or painting a room not used for business) and are not
deductible.
Certain
expenses of your home are deductible whether you have a business
or not. Real estate taxes, mortgage interest, and casualty
losses can all be deducted as itemized deductions on your
personal tax return. For these deductions, take the
business usage percentage of these costs as a home office
deduction, and deduct the balance on your Schedule A as itemized
deductions.
Other
expenses, such as depreciation, insurance, rent, repairs,
security systems, utilities and services are only deductible if
you have a home office. You can deduct the portion of
these expenses that apply to the business use of your home using
the business percentage calculated earlier.
A
note about telephones:
the basic telephone service charge for the first
telephone line into your home is a non-deductible personal
expense. However, any
business long-distance charges made on that line, as well as the
cost of a second line into the home that is used exclusively for
business, are deductible business expenses.
They can be deducted even if you do not qualify for the
home office deduction. They
should be included in your business expenses on your Schedule C.
Keep
in mind that if you use a very small percentage of your home as
an office, such as 10%, you need to use that percentage to
compute your deduction for utilities, trash removal, mortgage
interest, real estate taxes, and rent. The deduction, then, may
not amount to as much as you anticipated. But it is worth your
while to gather the information and see what it would be.
Here is a handy little tool that will help you calculate what
the home office deduction would be for you: http://www.toolkit.cch.com/text/P07_2740.asp
Another thing to
keep in mind is that the home office deduction cannot trigger a
loss for your business. For instance lets say that you had
business income of $20,000 and business expenses (not including
the home office deduction) of $17,000. This leaves you
with a net profit of $3,000. If your home office expense
is $5,000, you would only be able to claim $3,000 for the home
office expense. If you already have zero income or a loss
before the home office deduction, you won't be able to take any
of it. However, all is not lost, as you can "carry
forward" any home office deduction that you are not able to
take because of this rule. This means you can apply any
unused portion to future tax years.
Complications
When Selling your Home
If you qualify
for and claim the home office deduction, there will be
additional issues to deal with when it comes time to sell your
home.
First of all, any
depreciation you take (or were eligible to take) will reduce the
basis of your home, and consequently have an impact on any
capital gains tax you may owe on the sale. For many
people, this won't be an issue. The way the law stands
now, if you have lived in your home and used it as your
principal residence for two of the five years prior to selling
your home, you can exclude from income up to $250,000 (or
$500,000 if married filing jointly) of any gain you receive on
the sale of your home. This means that as long as you make
less than $250,000 (or $500,000 MFJ) profit when sell your home,
you will not owe any capital gains tax on the sale.
HOWEVER, if your business area is located in a separate
structure, such as a garage or other free-standing structure
located on your property, the capital gains tax exclusion DOES
NOT APPLY to this part of the sale, and you may end up owing
capital gains taxes on a percentage of the profit. If this
situation applies to you, I recommend you talk with a tax
professional before selling your home to see how this will
affect you.
But
whether your business use is outside your residence or inside,
if you have claimed the home office deduction you will have to
"recapture" any depreciation you took (or could have
taken) for business use of your home after May 6, 1997, up to
the amount of any gain realized on the sale. This means
that the amount of any depreciation you took (or could have
taken) will be taxed at a rate of 25% in the year you sold your
home.
Depreciation
"Allowed and Allowable"
The
"depreciation allowed or allowable" rule means that
you cannot avoid either the reduction in basis of your home, or
the depreciation recapture rule by just not claiming
depreciation as a home office deduction. Whether you claim
the depreciation or not, if you qualified for the home office
deduction, the amount of depreciation you COULD HAVE CLAIMED
will need to be deducted from your home's basis, and recaptured
in the year of sale.
As you can see,
the home office deduction is a bit complicated and not everyone
that works from home will qualify. But if you haven't at
least looked in to the possibility, you owe it to yourself to do
so now. And if you qualify but have not taken it because
of concerns about selling your home, the recent changes that
remove most home offices from capital gains taxation is a good
reason to re-think your decision.
For
more information about the home office deduction, see
Publication
587 - Business Use of Your Home.
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