Yeend, Castaneda & Flynn, LLP

With easy Internet access, more and more people are working in home-based businesses and having an office in their home. Having a home office can provide deductions on your tax return, but can also create extra headaches when you sell your home.

 

Requirements

The home office must be used regularly and exclusively:

As the principal place of business for a trade or business;

As a place to meet with clients, patients, or customers in the course of the trade or business; or

In connection with the taxpayer's trade or business, if the location is in a separate structure not attached to the dwelling unit.

Note: Daycare businesses are exempt from the "regular and exclusive" requirement

 

The Internal Revenue Code allows taxpayers to claim a deduction for home-based business expenses if they meet certain requirements.

If you are an employee, your employer must require the business use of your home for his or her convenience.

A deduction may be allowed for inventory storage if the product is regularly sold to others and there is no other fixed location available for the business.

Before 1999, the courts had interpreted the "principal place of business" very narrowly and disallowed a deduction if the office was solely for administrative and management activities, rather than for the actual generation of income. The Taxpayer Relief Act of 1997 changed this, effective January 1, 1999 . Now, a deduction for an office used solely for those activities is allowed if there is no other location available to perform them.  

 

Calculations

Direct and indirect expenses are considered when making home office calculations.

Direct expenses are those that pertain exclusively to the home office, such as painting the walls or installing new carpeting.

Indirect expenses are those that pertain to the entire residence, such as rent, mortgage interest, taxes, insurance, repairs, utilities, casualty losses, and depreciation.

Indirect expenses must be allocated between the business and non-business portions of the home.

The most accurate method of allocation is to divide the square footage of the office by the total amount of usable space in the home. If rooms are of approximately equal size, you can divide the number of rooms used for business by the total number of rooms.

With a daycare business, multiply this business percentage by the fraction obtained by dividing the number of hours the home is used for business by the total number of hours in the year (8,760 hours, except in leap years).

Once these figures are known, the indirect expenses are multiplied by the business percentage in order to apply the limitations.  

 

Limitations

The amount of expenses that can be deducted are subject to specific limitations and ordering provisions.

The overall limitation is based on the taxpayer's net income from his trade or business.

For an employee, this is wages less other business expenses listed on Form 2106.

For a self-employed person, this is the net income shown on Schedule C without the home office deduction.

If there is a loss, no deduction is allowed and the expenses are carried forward to future years when there is net income.

Once the otherwise deductible expenses have reduced net income, the other business expenses are deducted.

If net income remains at that point, depreciation is deducted.

Any time net income reaches zero, the balance of the expenses is carried forward.

If the taxpayer goes out of business before using these amounts, they are lost.

 

Three deductions are allowed in full regardless of the net income limitation. They are allowed under other code sections and may create a Schedule C loss. These must be claimed in full before using any other expenses:

Mortgage interest

Real estate taxes

Casualty or theft losses

 

Sale of Property and Exludible Cain

When you sell the home that had been the location of your home office, some of your gain may be taxable.

The depreciation allowed to be claimed on your home office is subject to taxation even if it meets the personal use rules. This depreciation is considered "unrecaptured Section 1250 gain" and will be taxed at a maximum rate of 25%. The remaining gain is eligible for the exclusion.

If you are renting your principal residence to your employer, these potential tax situations are avoided.

 

Planning Considerations

Home office expenses can represent a significant dollar amount in computing your tax liability. If you think your situation meets the requirements, talk to your tax advisor for more specific details on how to qualify for this deduction.

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National Association of Tax Professionals (NATP)
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