The home office deduction can help you save money on your taxes if you regularly and exclusively use part of your home for business.
What can I deduct on my taxes? This is a common question for everyone who works from home. If you meet the tests for the home office deduction (regular and exclusive use), you can deduct prorated amounts for
- home mortgage interest (or rent)
- utility bills
- home repairs and
- depreciation
Even if you don't meet the home office tests, you can still deduct expenses for items used in your business (business expenses) and homeowner's deductions (e.g., mortgage interest and property taxes).
Should I claim the home office deduction?
As a general rule, you should never shy away from taking a deduction you are legally entitled to claim. This holds true when it comes to the home office deduction. However, the home office deduction is highly scrutinized by the IRS, so it is essential that you fully understand the rules and that you keep meticulous records of all your claimed expenses.
There are those who have dangerous misconceptions about the way the deduction works. Perhaps you have heard about folks who furnish their entire home in rare antiques and write them off as a "business expense." Or people who think the deduction entitles them to pass on the cost of a new stove or hot tub to the government.
This article will provide you with the information that you need to evaluate whether you can claim a home office deduction.
Warning
This article focuses solely on the tax issues involved in operating a home office. There are a number of extremely important non-tax aspects.
Before operating a business out of your home, you need to determine if it is legal to do so and if you need any special permits from you local government in order.
Home office deduction prorates home expenses
Although everyone uses the shorthand "home office deduction" to refer to amounts that you can claim if you operate your business from your home, it is important to realize that the home office deduction is actually many deductions for different types of expenses. Among these expenses are a prorated amount of your:
- home mortgage interest (or rent)
- utility bills
- home repairs and
- depreciation.
The common denominator among these deductions is that the IRS has devised a single test to determine whether you qualify for all of them. If your working space doesn't meet the "home office" tests, these expenses are either non-deductible personal expenses (such as rent, painting the room or repairing the furnace) or deductible only as itemized deductions (such as mortgage interest or real estate taxes.)
Tip
The portion of expenses that are tied to your home office are totaled up and reported on IRS Form 8829, Expenses for Business Use of Your Home.
Some expenses can be claimed without a home office
Although qualifying for the home office deduction allows you to deduct more expenses that you can deduct without a home office, it is very important to remember that many expenses related to your business are deductible even if you don't have a home office.
These expenses fall into two major categories: business expenses and homeowner's deductions.
Business Expenses. Costs that are business expenses (ordinary, necessary and reasonable) are deductible even if you don't qualify for the home office deduction. For example, office supplies, postage, and the cost of bringing a second telephone line into your home for business use may deductible. In addition, you may be able to depreciate (or expense) the cost of computers and office furniture you buy to use at home, even if you're not allowed to deduct the cost of the office itself.
Homeowners' Deductions. If you would be entitled to claim an itemized deduction for an expense related to your home, you can claim that without regard the home office deduction. For example, home mortgage interest and real estate taxes would be allowed as an itemized deduction on Schedule A of your tax return in any case, even if you can't take a home office deduction.
The advantage of the home office deduction is that the portion of these expenses that relate to the home office can be deducted as "business expenses" in arriving at your gross income, which provides a must more substantial tax break.
Strict rules govern home office deduction
The requirements that you must meet in order to claim a home office deduction are strict and they are strictly enforced. To deduct home office expenses, you must satisfy tests relating to the space itself--exclusive and regular use--and the purpose of your use--principal place of business or meeting customers. Let's examine each of these requirements in turn.
Regular business use is essential
To qualify as a home office for tax purposes, it is essential that you use the space "regularly." Occasional use is not sufficient. If your office is your principal place of business, you will have no trouble meeting the "regular use" requirement.
However, if your home office isn't your principal place of business, but you use it to meet with clients, then you may find the regular use requirement challenged. A few client meetings over the course of the year is not going to entitle you to a deduction. It is necessary to prove that you regularly meet with clients.
As with any business deduction, you must keep good records to substantiate your claims. At the minimum, record the date and length of each meeting.
Tip
Although it's nearly always called the "home office" deduction, you don't necessarily have to use a portion of your home as an office: you could use part of your home as a showroom, lab, or storage area.
Space must be used exclusively for business
You must use the space exclusively for business. The exclusive use requirement is construed very strictly. Many deductions are lost because the space is not used exclusively for business.
"Exclusive use" means that the business part of the home can not be used for any (not even the slightest!) personal, family, or investment activities, or for any other business activities that don't meet the home office requirements.
Warning
If your return is audited, and you have claimed a home office deduction, don't be surprised if the IRS wants to visit your home office as part of a field audit. They will be looking for games or your kid's homework assignments on the computer. They will be looking for recreational equipment, such as a TV or a Wii Fit in the office space.
And, yes, an employee at a desk in a traditional office may well have Angry Birds or the novel that he or she is writing on the computer and the IRS would not blink. But don't expect that same treatment when a home office deduction is being scrutinized. (It's tax law—it's not supposed to be fair.)
However, keep in mind that the home office deduction refers to writing off a portion of your otherwise non-deductible house expenses (such as the electric bill.) So, if you didn't claim a home office deduction, but only a deduction for the business use of that computer, the mere existence of a few personal files would not cost you that deduction.
Exceptions to exclusive use requirement
There are a few exceptions to the "exclusive use" requirement:
- Inventory storage provided the home is the only fixed location of a retail business;
- Licensed day care facility; and,
- Separate structures.
Inventory storage exception. If your home is the only fixed location of a retail or wholesale business, you can deduct expenses that pertain to the use of part of your home for the storage of inventory or product samples.
Example
Patrick Daley's home is the sole, fixed place of his business selling personal computers at retail. He regularly uses half of his basement for inventory storage, although he also uses that part of the basement for personal purposes when his inventory is low. The expenses allocated to the storage space are deductible even though he does not use that part of the basement exclusively for business.
In order to meet the home office requirements, your home must be used regularly and exclusively for business—unless you meet one of the exceptions. Your home must also be your principal place of business, or be used to personally meet with clients or customers in the normal course of your business.
Day care provider exception. There is also an exception to this exclusive use requirement for those who operate a child care business in their home. The portion of the home that is used regularly for day care qualifies as a "home office," even if it is also used for personal and family living space. However, day care operators face an additional time restriction: they may only deduct expenses for the actual time the day care center was open.
Separate structure exception. If your home office is a separate structure that is not attached to your residence, you may qualify for the home office deduction without meeting the exclusive use requirement. In this situation, the structure merely has to be used in your trade or business.
Principal place of business test
The "principal place of business" test is significantly easier to meet than it once was. Currently, a home office will qualify as the principal place of business if:
- the office is used by the taxpayer to conduct administrative or management activities of a trade or business, and
- there is no other fixed location where the taxpayer conducts substantial administrative or management activities of the trade or business.
The test looks at "administrative" and "managerial" activities. Administrative or managerial activities include: billing for services, keeping books and records, ordering supplies, and scheduling appointments. So, you can meet the test even if you perform substantial non-administrative or non-managerial activities outside your home.
The fact that you may conduct management activities in a non-fixed location, such as a car or hotel room, will not cause you to lose the deduction. Similarly, the fact that you conduct some management activities in another fixed location of the business will not cause you to lose the deduction, as long as those activities are not "substantial."
In addition, the following activities will not stop you from taking a home office deduction, assuming you meet the other tests:
- Paying others to perform administrative activities outside of your home (for example, you hire a bookkeeper to do your payroll and she works from her office.)
- Doing occasional administrative activities at a fixed location outside your home (for example, you make the work schedules for the week from your home office, but you make an adjustment while at your retail store when an employee phones in sick)
Example
Les owns a roofing business. He has turned one of the rooms in his home into an office where prepares his invoices, orders supplies, and prepares his payroll checks. He normally schedules appointments from the home office, but will make a confirming call from the job site.
The hours that he spends installing a roof are not considered administrative or managerial, so they do not jeopardize his right to a home office deduction. Moreover, a call to confirm directions or an appointment time is not a substantial part of his scheduling work, so those calls are okay as well.
It doesn't matter if you have suitable space to conduct administrative or management activities outside your home, as long as you don't make use of it for that purpose. For example, you have a room at your restaurant that could function as an office, but you do not use it for that purpose.
Meeting patients, clients, or customers may qualify
As noted earlier, your home office doesn't have to be your principal place of business if you regularly use it for client meetings. So, even if you don't meet the "administrative and managerial" test, you can satisfy the "principal place of business" requirement if you conduct business with patients, clients, or customers in your home in the normal course of your business. Doctors, dentists, attorneys, and other professionals who maintain offices in their homes generally will meet this requirement.
You must meet both of the following requirements:
- You must meet in-person with patients, clients, or customers on your premises. Phone consultations don't count.
- The number of meetings must be substantial and integral to the conduct of your business. An occasional meeting with a vendor would not count.
If you meet these two tests, the part of your home you use exclusively and regularly to meet patients, clients, or customers does not have to be your principal place of business.
Employee's Use Must Be for Employer's Convenience
Employees who wish to claim the home office deduction must meet all the standard tests. What's more, employees have an additional hurdle to meet--and one that few can meet: the regular and exclusive business use must be for the convenience of your employer. If your employer provides you with office space elsewhere, you probably can't take the home office deduction because your home would not be considered your principal place of business.
Example
Megan works from home three days a week. Her employer's liberal work from home policy allows her to reduce the time and cost of commuting to the corporate headquarters in a nearby suburb.
Megan's telecommuting arrangement is primarily for her convenience: She will not be able to claim a home office deduction, even if she only uses her study for work-related purposes.
In contrast, Matthew, who works for the same company, was required to work from home after the company decided not to reopen a branch office that was badly damaged in a flood. Matthew works at home for the convenience of the employer. If he meets the other tests, he can qualify for a home office deduction.
Employee's Can Claim Only an Itemized Deduction. Not only is the regular and exclusive use requirement tougher to satisfy for an employee, any home office expenses can only be claimed by individuals who itemize. Employees, including outside sales reps, must itemize deductions on Schedule A (Form 1040) to claim a deduction for the business use of a home, in the same way that they must itemize to claim any other employee business expenses.
No deduction for space rented to employer
The IRS specifically prohibits you from taking the home office deduction if you rent all or part of your home to your employer and then use the rented portion to work in as an employee.