Small Business Taxes & Management^TM--Copyright 2018, A/N Group, Inc.

Introduction

A home office deduction can provide tax savings ranging from minor to substantial. You may be entitled to a home office deduction if you are self-employed. Beginning in 2018 most miscellaneous itemized deductions (reported on Schedule A of Form 1040) are not allowed. Thus, employees who have a home office aren't allowed a deduction. You should be aware that there's a good chance taking the deduction will increase your chances of an audit. The IRS knows there are a number of mistakes taxpayers make when claiming the deduction, and that often leads to a tax adjustment on audit.

Qualifying for the Deduction

To qualify for the deduction you must use part of your home:

• Exclusively and regularly as your principal place of business,
  
• Exclusively and regularly as a place where you meet or deal with patients, clients, or customers in the normal course of your trade or business,
  
• In the case of a separate structure which is not attached to your home, in connection with your trade or business,
  
• On a regular basis for certain storage use, or
  
• As a daycare facility.

We won't discuss all the issues related to a daycare facility. For more information on that issue, see IRS Publication 587.

The above requirements sound easy enough to meet, but the IRS has strictly interpreted some of the requirements. There's a good chance you won't meet the basic requirements so we'll review them first.

First, the home office deduction only applies to a business. Managing your investments is not a trade or business.

Second, the space must be used exclusively for the business. That means you can't use the space for any other purpose. For example, Sue is an independent sales rep for a clothing manufacturer and uses a spare bedroom to plan trips, take orders, and do other paperwork. She has no other fixed location. The bedroom has a computer, separate phone line, filing cabinets, etc. Several times a year relatives visit and stay in the room. Sue hasn't met the exclusive rule and can't take the home office deduction. The same would be true if there was a bathroom accessible only through the bedroom that was used by house guests or family members (other than by Sue). On the other hand, part of a room may qualify if it's clear the area is strictly for business.

Caution--More than one taxpayer has argued that he qualifies for a home office deduction because he used a large percentage of the house. But that won't play if it's not exclusive. For example, one taxpayer did use 40% of his apartment for business--records were stored in closets, in bedrooms, etc., but there was no space used exclusively for business.

The principal place of business requirement is fairly broad. Principal doesn't mean only. You can have more than one business location for a single trade or business. If you have more than one, to qualify your home as a principal place of business, you've got to consider the relative importance of the activities performed at each place where you conduct business, and the amount of time spent at each place where you conduct business.

Your home office will qualify as your principal place of business if you use it exclusively and regularly for administrative or management activities of your trade or business and you have no other fixed location where you conduct substantial administrative or management activities of that business.

Example 1--Fred is a self-employed mechanic who fixes a range of shop machinery. He often writes up estimates in his truck. He has no office to do paperwork such as billing, accounting, etc. other than his home office. Even though he earns his income from the work at the job sites, his home office qualifies because he has no fixed location to do paperwork.

Example 2--Sue owns three bicycle shops as a sole proprietorship. She has a small office at each shop to keep the store's computer system and certain records. Although she does some administrative work at the store locations, the offices aren't suitable so she does the majority of her administrative work at her home office. She spends more time on administrative functions in the home office that at the store locations. Here home office qualifies.

Example 3--Fred is self-employed psychologist. The hospital where he does most of his counseling provides him with a small office. However, he uses the office only to conduct research and store patient records. He uses his home office for all administrative activities.

The following activities performed by you or others will not disqualify your home office from being your principal place of business.

• You have others conduct your administrative or management activities at locations other than your home. (E.g., another company does your billing from its place of business.)
  
• You conduct administrative or management activities at places that are not fixed locations of your business such as in a car or hotel room.
  
• You occasionally conduct minimal administrative or management activities at a fixed location outside your home.
  
• You conduct substantial nonadministrative or nonmanagement business activities at a fixed location outside your home (For example, you meet with or provide services to customers, clients, or patients at a fixed location of the business outside your home.)
  
• You have suitable space to conduct administrative or management activities outside your home, but choose to use your home office for those activities instead.

Meeting with patients, clients and customers. You may have a regular office where you meet with clients, patients, etc. and do all your paperwork, but also maintain an office in your home for meeting patients, etc. This office may qualify for a home office deduction. To do so you must physically meet with patients, clients, or customers on your premises and their use of your home is substantial and integral to the conduct of your business. Use of the home for occasional meetings and telephone calls will not qualify.

Example--Sue is a self-employed surgeon who performs operations at and has an office in a Boston hospital. She meets with patients in that office. She has an office in her home in a Boston suburb where she does preoperative interviews and follow-up meetings with patients who find her home office more convenient. On average she has several visits per week from patients. The home office qualifies for a deduction.

Inventory storage. The space may qualify for a home office deduction if you use it for storage of inventory or product samples. In this case you don't have to meet the exclusive use test. That is, you use a portion of your basement to store samples and inventory. Even though you also use the space for access to your garage, the space can qualify. 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 a separately identifiable space suitable for storage.

Separate structure. You can deduct expenses for a separate free-standing structure, such as a barn, garage, workshop, etc. if you use it exclusively and regularly for your business. Here the structure does not have to be your principal place of business or a place where you meet clients, patients, etc. For example, Fred is a carpenter who makes built to order bookcases, cabinets, and specialty designs. He has a showroom and shop where employees create the projects, but has a barn in his backyard where he stores lumber, hardware, etc. and works on some projects on his own. The barn qualifies as a home office.

Multiple businesses. You can use the same home office as the principal place of business for multiple trades or businesses, but the determination of whether the office qualifies for a deduction is made separately for each business.

Computing the Deduction

Introduction. We'll go into some detail with the background for the computations of the deduction, but we strongly suggest you use tax software if you intend to claim the deduction. First, it'll make the computations much easier. Second, it'll pick up fine points such as carryover rules and limitations that you might miss.

Keep in mind that special rules apply to use of your home as a daycare facility. We won't deal with that here.

Percentage of home. Most of your expenses such as real estate taxes and mortgage interest have to be apportioned based on the percentage of your home used for business. For example, the total square footage of your home is 1,500 and you use 120 square feet (10 feet by 12 feet) for a home office. You can deduct 8% of your mortgage interest, etc. for your home office. (It's more complicated for daycare facilities.) The instructions allow you to compute the percentage on either square footage or number of rooms, but only if the rooms are relatively equal in size. That's generally unlikely and the area method is used most of the time. The instructions also allow "any reasonable method" but be careful if you're thinking of using a method other than the two just described.

Expenses in the computation. The first step is to accumulate the expenses associated with your home. There are three types of expenses--direct, indirect, and unrelated. Unrelated expenses are those that apply only to parts of your home not used for business. That could include lawn care, pool maintenance, landscaping, etc. It also includes work done to a room not used for business. For example, painting the kitchen. No portion of these expenses are deductible.

Indirect expenses are those for keeping up and running your entire home. Examples include mortgage interest, real estate taxes, casualty losses, homeowners insurance, utilities, general repairs. General repairs might include roof repairs, electrical work that applies to the whole house, etc. These expenses are entered in the "indirect expenses" column on Form 8829, Expenses for Business Use of Your Home and apportioned based on square footage or rooms.

The final category represents direct expenses. These are expenses applicable solely to the business part of your home. That could include painting and repairs to the room used for your home office. These expenses are directly deductible on Form 8829 (in the direct expenses column) and don't have to be apportioned. Chances are few expenses will fall in this category unless you have a separate structure.

Some expenses may fall into a special situation. You use the garage for your custom cabinet making. Power tools are running a significant part of the day. You may have to compute the electric use separately and enter that amount as a direct expense. The opposite could also be true.

The form provides for entry of casualty losses, deductible mortgage interest, real estate taxes, excess mortgage interest, insurance, rent, repairs and maintenance, utilities (include heating oil and gas, electric), and other expenses. Mortgage interest includes only the interest associated with that home--for purchase and home improvements--and does not include interest on a home equity mortgage. There are other special rules associated with mortgage interest.

Mortgage interest, real estate taxes and casualty losses require special handling. You'll enter the total amount here. Any amount not used for the home office deduction is deductible on Schedule A (if you itemize). Thus, for the year your mortgage interest is $12,000 and 15% of the home is used for business. Your deductible amount for the home office will be $1,800 (15% of $12,000); the remaining $10,200 is deductible on Schedule A. Real estate taxes are handled in a similar fashion. If you're using tax software to do the return and you enter the information correctly, the program will most likely automatically take these rules into account.

In the case of indirect expenses, you'll enter the total amount of the expense (e.g., mortgage interest of $12,000) in the indirect expense column; the apportionment will be computed later.

If you rent, rather than own your home, the computations are simpler. You won't have to worry about mortgage interest, real estate taxes, etc. The items of concern will be rent, insurance, utilities, and possibly repairs and maintenance and other expenses.

Certain expenses, such as telephone, shouldn't be apportioned. The first telephone line is not deductible. Special features, such as call waiting, may be deductible, but aren't part of your home office expense. A second line specifically for the office is deductible as a business expense on Schedule C.

One thing software may not take into account is partial year use of your home. For example, you only began using your home office on August 1. For this first year divide your indirect expenses for the full year by 12 and multiply by 5. Stopped using the home office at the end of April? Perform a similar calculation. Of course, that's assuming your expenses are approximately equal from month to month.

Depreciation. You can depreciate the portion of your home used for business. If you're not familiar, depreciation is an annual deduction based on the basis (cost) of the property and the life. Since this is business property, the life is assumed to be 39 years. Thus, if your cost basis in the home is $300,000 and you use 8% for business, your annual deduction would be $615 ($300,000 X 8% / 39). In addition, there's an adjustment for the first year the property is used for business. Follow the form instructions carefully. Tax software will take care of the mechanics here.

What's your basis in the property? Things are easy if you purchase the home and immediately convert a portion to business use. In that case your basis in the property is your cost. However, if you've owned the home for a time, your basis will be the lower of the price you paid for the home or the fair market value at the time business use begins. For example, you paid $300,000 for the home in 2014. You first use the home for business in 2018. You get an appraisal that shows the home is only worth $260,000. Your basis for depreciation will be $260,000. Had the value increased to $350,000, your basis for depreciation would be $300,000. (In all case the basis excludes the land, see below.)

Your basis includes not only the original cost but any permanent improvements made to the home since acquisition. A permanent improvement increases the value or adds to its life, or gives it a new or different use. Examples include replacing plumbing or electrical wiring, an addition, remodeling, or a new roof. Your basis could also be reduced by depreciation taken in an earlier year, for example, if you rented the property or used a portion as a home office.

Because land is not depreciable, you must also make an adjustment for its value. For example, your basis in the home is $300,000 (lower of cost or fair market value), but $50,000 of the value belongs to the land. Thus, only $250,000 is subject to depreciation. How do you allocate a portion of the value to the land? Generally, you should be able to use any split shown on your local real estate bill. In some situations, where you have a substantial amount of land, or the land has a very high value, this won't work. Talk to your tax professional. You may need an appraisal.

Additions after you begin using the home for business are depreciated separately. Additions specifically for the business, such as drywalling, painting, permanent walls, etc. to a garage to enable you to operate your machine shop should be depreciated separately and not apportioned.

Shelving, filing cabinets (unless they're permanent as in built in), in the home office or special electrical lines, a hydraulic lift, etc. in a workshop are depreciated separately and may qualify for expensing under Section 179. Special rules may apply to property converted from personal to business use.

Part II

Click on the link for the second part of this article that include specials considerations, the safe harbor rule, and some examples.

--Last Update 05/11/18