Are you working from home or planning to set up a “home office” for convenience and cost savings? Generally, the only deductible expenses related to your personal residence are interest and property taxes. If you have a “home office,” you may be entitled to deduct much more. To get all the deductions you deserve, take some time to learn how the rules apply to you.
For deduction purposes, the IRS has a strict definition of “home office.” Nonbusiness, profit-seeking endeavors such as investment activities do not qualify. The office must be used “regularly and exclusively” for business. It can’t double as your guest room or storage area for personal items.
Also, the office must either be your principal place of business or a place where you meet or deal with clients or customers. This requirement is easy to meet if your home office is your only business location. It gets more complicated if you have another workplace. Employees qualify for home-office deductions only if they work at home for the convenience of their employer.
What home-office expenses are deductible? If you qualify, you may deduct both direct and indirect expenses related to your home office. Direct expenses include repairs, paint or additional insurance for the office area. Indirect expenses include costs to operate your home, such as property taxes, mortgage interest, rent, repairs, security systems, telephone, utilities, insurance and depreciation. The business percentage is typically computed using the ratio of the area used for business to the total area of the home.
Home-office expenses can only be utilized to offset the amount of gross income from the business activity performed in the home office. However, deductions not allowable by reason of this limitation may be carried forward to the next year.
Are home-office deductions a “red flag” for audit? This is a widely held notion, though there doesn’t seem to be any clear evidence to support it. But the IRS does place a heavy burden of proof on the taxpayer to establish that home-office expenses are deductible. You must keep complete and accurate records to substantiate your deductions.
When you sell your home, you will have to pay tax on the gain to the extent you have taken depreciation deductions on your home office. This is true even if you get to exclude the rest of it under the $250,000/$500,000 exclusion for gain on sale of a principal residence.
If the office is physically part of the residence, the entire home qualifies for the home-sale exclusion, except for the depreciation previously allowed. If you move or set up your office in a free-standing garage or guest house, you will lose out on a significant portion of the home sale exclusion. For separate buildings, the full amount of the gain attributable to that property is taxable.
For those who work from home, proper planning can mean a big difference when it comes to the tax bill. Questions? Feel free to e-mail me or consult with your tax adviser.
Mary Decker is a CPA, Certified Financial Planner and a principal of Hascal Sjoholm &Co., a full-service CPA firm in Everett. She specializes in tax and estate planning. She can be reached online at www.hascal.com or at 425-252-3173.
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