A home office may be defined as a room within your home, a portion of a room within your home, or a separate structure appurtenant to your home that you use exclusively and on a regular basis to conduct business activities. If you use a home office to run a business, either as an administrative office or as a place in which to make, assemble, or prepare items that you sell, you may be able to deduct part of your housing expenses (such as rent or utilities) on your federal income tax return. This deduction is known as a home office deduction. To take this deduction, you will need to file Form 8829. This is generally true whether you use your home for business purposes as an employee or for a business of your own. But be aware that the IRS has taken a strict stance towards home office deductions, establishing specific rules that, if not met, could disallow your taking a home office deduction.
What Constitutes Your Home?
Your home can be your house, condominium, apartment, mobile home, or boat, so long as you live in it. It is important to note that your home office need not be located inside your home; a structure appurtenant to your home, such as a shed or garage, can qualify as a home office if all applicable requirements are met. To even consider the home office deduction, you must use the applicable portion of your home in an activity that qualifies as a trade or business.
For example, if you exclusively and regularly use a room in your home to read information and analyze stocks and mutual funds that you invest in, you will not be able to take a home office deduction, since your activity does not qualify as a trade or business.
What Two Tests Must be Satisfied Before You Can Qualify For a Home Office Deduction?
If you want to qualify for a home office deduction, you must meet two threshold tests:
• The place of business test
• The exclusive and regular use test
Place of Business Test
In order to meet this test, you must show that you use a portion of your home as:
• The principal place of business for any trade or business you conduct, or
• A place where, in the normal course of your business, you regularly meet with clients, customers, or patients, or
• In the case of a separate structure that is not attached to your dwelling unit, you must show that you use it in connection with your trade or business (i.e., it needn’t be your principal place of business).
Your home office will qualify as your principal place of business for purposes of deducting expenses for its use if you meet the following requirements:
• You use it exclusively and regularly for administrative or management activities of your trade or business
• You have no other fixed location where you conduct substantial administrative or management activities of your trade or business
However, if the preceding does not apply and you do business at more than one location, your principal place of business is determined using a two-part test:
• What is the relative importance of the activities performed at each business location?
• How much time do you spend conducting these activities at each place of business?
The IRS will look at the relative importance portion of this test first to decide which place of business is your principal place of business. If this is inconclusive, then it will look at the time portion of this test to determine where most of your business activities take place.
Assume John is a doctor who works 40 hours per week at a local HMO, where he meets and attends to all of his patients. Since his employer provides him with examination space but not with office space, John uses a room in his home exclusively as an office 10 hours each week. John uses the office space to engage in billing and other business-related paperwork, to correspond with insurance companies, and to read medical journals. John could qualify for a home office deduction, since he conducts substantial administrative and management activities for his business on a regular basis and uses his home office exclusively for business purposes.
Exclusive and Regular Use Test
In addition to the place of business test, you must also pass the exclusive and regular use test before you can take a home office deduction. To pass this test, you must show that you exclusively use a portion of your home for your trade or business on a regular basis.
Example 1: You’ve set aside one room in your home as your office from which you manage the investment real estate you own. But, in addition, you use this room as your children’s playroom. Here, you wouldn’t meet the exclusive use test.
Example 2: Assume the same facts as example one, except that you’ve taken a large room in your home and divided it in two with a room divider. Half you use exclusively for your office, half you use as your children’s playroom. In this case, you would meet the exclusive use test. (And note, although the divider used in this example is helpful, it is not required to meet the exclusive use test.)
Example 3: You’ve set aside a small room in your home that you use exclusively as an office to run a side business, selling insurance. However, since you engage in this business only intermittently–not on a regular basis–you will not be allowed the home office deduction. You don’t pass the regular use portion of the test.
If your business involves selling a particular product or products and you run the business out of your home, you can take a home office deduction for that portion of your home that you regularly use to store inventory or samples of the product or products. This only applies if the space is a separate space that is suitable for storage, and your home is the sole fixed location of the business.
If the business use of your home is running a day-care center for children, elderly, or handicapped citizens and you have met state licensing rules, then you need not meet the exclusive use test, so long as a portion of your home is regularly used to provide the day-care services.
What if You Conduct Multiple Businesses From Your Home or Use Your Home to Conduct Only a Sideline Business?
Perhaps you use your home as an office or business space to conduct multiple businesses, or you use your home office for both a business you run and for business that you do for an employer. If so, you must be sure that each separate business use meets all of the required tests and rules relating to the home office deduction. Note that you may not be able to satisfy the exclusive use test if you use the same home office to conduct more than one trade or business activity.
You run a T-shirt production and sales business out of your home’s basement, which meets all of the tests and rules for the home office deduction. However, you also use the desk, computer, and copy machine portion of the basement to do the paperwork for your full-time job.
Because your employer at your full-time job provides you with an office, the use of your home does not qualify for the home office deduction. Furthermore, because of the mixed use of your basement, the IRS may also disallow the deduction for the T-shirt business (for failure to satisfy the exclusive use test).
Which Home Office Expenses Can You Deduct?
You can deduct both direct and indirect expenses that apply to a portion of your home that you use for business purposes. Direct expenses are costs expended solely on the portion of your home you use for business purposes. These can be deducted in full.
You use one room in your home exclusively for business purposes. You spend $300 to have that room painted and $100 to have a separate phone line jack brought into that room. You can deduct the entire $400 as a home business expense.
Indirect expenses are costs that benefit your entire home, including the portion of your home that you use for business purposes. You can deduct the business percentage of these expenses.
You use a room in your home exclusively for business purposes. The square footage of the room equals 20 percent of the square footage of your home. You spend $3,000 to paint the exterior of your home. This is an indirect expense–you can deduct $600 (20 percent of $3,000) as a home office deduction.
How do You Calculate Your Business Percentage?
You can use any reasonable measure to calculate the percentage of your home that you use for business purposes. The two most common, however, are the:
Square foot method
Divide the square footage of the portion of your home that you use for business purposes by the total square footage of your home. For example, your home is 2,000 square feet, and you use one room that is 200 square feet. Your business percentage is 10 percent (200 divided by 2,000).
Number of rooms method
If all the rooms in your home are relatively equal in size, divide the number of rooms you use for business purposes by the total rooms in your home. For example, your home contains 10 rooms of relatively equal size, of which 2 are used exclusively for business purpose. Your business percentage is 20 percent (2 divided by 10).
Which Expenses are Deductible?
The following expenses are considered deductible expenses:
Deductible mortgage interest
This is an indirect expense and also includes any interest you pay on a second mortgage secured by a home you own and live in. (However, other rules may limit the amount of your home mortgage interest deduction.)
Real estate taxes
Taxes paid on a home you own and live in. This is an indirect expense. After you calculate the business portion of your deductible mortgage interest on Form 8829, you should then subtract that amount from your total deductible mortgage interest. The remainder can be deducted on your Schedule A itemized deductions. The same applies to your real estate taxes.
Rent
Rent you pay on a home you live in (this includes rental of a house, apartment, condominium, or any other qualifying residence if it includes a qualifying home office) is an indirect expense.
Utilities
This includes electricity, gas, cleaning, and trash removal. These are almost always indirect expenses. Expense such as the fee that is charged by an Internet service provider may be a direct expense, if you can show it is used exclusively for business purposes.
Insurance
This would include homeowners insurance or apartment insurance. This is an indirect expense.
Telephone
You cannot deduct the basic cost of the main telephone line into your home. However, you can deduct the cost of long-distance telephone calls for business purposes used on this or another phone line, as well as the cost of other phone lines brought into your home to be used for business purposes.
These expenses are reported separately from the home office deduction when reported on a Schedule C.
Repairs
Repairs to your home that keep it in good working condition. For example, furnace repairs, painting, and a new roof are deductible. These are indirect expenses.
Casualty losses
If part of your home (or its contents) is damaged or destroyed, you can deduct the value of the loss, minus any salvage value and/or insurance reimbursement you receive. Whether this loss is treated as an indirect or direct expense will depend on the part of the home and/or contents that are damaged or destroyed.
Security systems
You can deduct the business percentage of this indirect expense if the security system protects all doors and windows and other entrances or exits into your home. In addition, you may be able to take a depreciation deduction for that part of the security system that relates to the portion of your home used for business purposes.
Depreciation
Certain property that you can use for more than one year may be depreciated for income tax purposes. This can include (but is not limited to) a building (or permanent improvement to one), furniture, equipment (such as a computer or copy machine), or security system. You may be able to take a deduction for depreciation on such property.
If you’re a homeowner and meet all requirements, you can generally exclude up to $250,000 of gain ($500,000 if you’re married and file jointly) from federal income tax when you sell your home. You may end up paying some taxes, though, if you have a home office. The capital gain on the sale of your home will not qualify for this exclusion to the extent of any depreciation deductions you claimed after May 6, 1997. You should consult an attorney for more details.
If you are starting a new business, pay particular attention to determining whether the costs of property acquired for use in the trade or business can be recovered through depreciation deductions or through Section 179 deductions.
Claiming a home office as your principal place of business can also have implications for your ability to deduct certain transportation expenses. If your principal place of business is your home, you may deduct daily transportation expenses incurred in traveling between your home and another work location.
Jill is an architect whose principal place of business is in her home. During the week, she drives from her home to clients, construction sites, the post office, and office supplies stores. Her mileage for all of these trips is considered business mileage.
Are There Any Limits on Deductibility of Home Office Expenses?
If the total amount of business expense for the business use of your home (including depreciation) is less than or equal to your total gross income from the business use of your home, you can deduct all of these expenses. However, if gross income is less than total expenses, your home office deduction may be limited. (You may, however, be able to carryover any excess deductions to the next tax year.)
The rules relating to limits on home office deductions (and on the deductibility of depreciation) are very complicated. Accordingly, if you have excess deductions or may be including depreciation as part of these deductions, it’s wise to consult with your accountant and/or tax attorney.
What Happens When You Sell Your Home?
If you’re a homeowner and meet all requirements, you can generally exclude up to $250,000 of capital gain (up to $500,000 if you’re married and file jointly) from federal income tax when you sell your principal residence. You may end up paying some taxes, though, if you have a home office; capital gain on the sale of your home will not qualify for this exclusion to the extent of any depreciation deductions attributable to the business use of your home after May 6, 1997.
In the past, the IRS took the position that if a principal residence was used partially for residential purposes and partially for business purposes (mixed-use property), any capital gain on the sale of the house would have to be prorated. Only the part of the gain allocable to the residential portion was eligible for exclusion.
Final regulations issued by the IRS, however, have adopted a more liberal position. So long as both the residential and non-residential portions of the property are within the same dwelling unit (e.g., one room in the home is used as a home office), all of the gain from the home sale (except for gain resulting from certain depreciation deductions) is eligible for the capital gain exclusion. However, gain is allocated if the business portion of the home is separate from the dwelling unit (e.g., an office in a converted detached garage).
Assume a self-employed accountant bought a home in 1998 and sold it several years later at a $20,000 gain. Although the house was always used as his principal residence, the accountant used one room within the house as his business office. Over the years, the accountant claimed $2,000 of depreciation deductions for his office. Under the final regulations, $18,000 of the capital gain will be tax-free. Only the $2,000 of the gain equal to the depreciation deductions will be taxable. The taxable amount will be considered unrecaptured Section 1250 gain, which is taxed at a rate of 25 percent.
If the accountant’s office had been located in a converted detached garage on his property, he would have to treat the sale as two separate transactions and pay tax on the gain allocable to the converted garage.
For more information, see Exclusion of Capital Gain on the Sale of Your Home. Also, read IRS Publication 587, Business Use of Your Home.
If you have questions regarding a home office deduction, the tax experts at Henssler Financial will be glad to help. You may call us at 770-429-9166 or e-mail at experts@henssler.com.
Disclosures
The following information is reprinted with permission from Forefield, a division of Broadridge Financial Solutions, Inc. This article is meant to provide valuable background information on particular investments, NOT a recommendation to buy. The investments referenced within this article may currently be traded by Henssler Financial. All material presented is compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. The contents are intended for general information purposes only. Information provided should not be the sole basis in making any decisions and is not intended to replace the advice of a qualified professional, such as a tax consultant, insurance adviser or attorney. Although this material is designed to provide accurate and authoritative information with respect to the subject matter, it may not apply in all situations. Readers are urged to consult with their adviser concerning specific situations and questions. This is not to be construed as an offer to buy or sell any financial instruments. It is not our intention to state, indicate or imply in any manner that current or past results are indicative of future profitability or expectations. As with all investments, there are associated inherent risks. Please obtain and review all financial material carefully before investing. Henssler is not licensed to offer or sell insurance products, and this overview is not to be construed as an offer to purchase any insurance products.
