Tax Tip for October 2001
Home
Office Expense Deduction for Self-employed Taxpayer
If
you're self-employed and work out of an office in your home, you should know
about the strict rules that govern whether you can deduct your home office
expenses.
You
may deduct your home office expenses if you meet any of the three tests
described below:
the separate structure test, the place for meeting patients, clients or
customers test, or the principal place of business test. You may also
deduct the expenses of certain storage space if you qualify under the rules
described further below.
If
you do qualify, you compute your home office deductions on Form 8829, and report
them above-the-line on Schedule C.
Separate
structures.
The easiest test to meet allows a deduction for the costs of a separate
unattached structure on the same property as your home—for example, an
unattached garage, artist's studio, workshop, or office building—that is used
as a home office. To qualify for the deduction, the separate structure must be
used exclusively and on a regular basis in connection with your business.
Home
office used for meeting patients, clients, or customers.
Alternatively, you may deduct your home office expenses if you use the home
office exclusively and on a regular basis, to meet or deal with patients,
clients, or customers in the normal course of your business. The patients,
clients or customers must be physically present in the home office. Telephone
calls to them from your home office won't do the trick.
Principal
place of business.
In addition, you may deduct your home office expenses if you use your home
office, exclusively and on a regular basis, as your principal place of business.
There
are two tests for determining whether a home office is a principal place of
business—the “management or administrative activities” test, and the
“relative importance/time” test. If your home office satisfies either
of these tests, it will be treated as your principal place of business.
Management
or administrative activities test.
A home office will qualify as the taxpayer's “principal place of business”
if the taxpayer uses the home office to conduct administrative or management
activities of the business, so long as the taxpayer doesn't have another fixed
location where the taxpayer conducts substantial administrative or management
activities of the business. According to IRS, the office must be used
exclusively, and on a regular basis, for the administrative or management
activities.
Relative
importance/time test.
In applying this test, there are two primary considerations in determining a
taxpayer's principal place of business: (1) the relative importance of the
activities performed at each location where the taxpayer's business was
conducted, and (2) the amount of time spent at each place. IRS says that it will
first apply the “relative importance” test by comparing the activities
performed at home with those carried on elsewhere. If this comparison clearly
shows where the principal place of business is, there's no need to look further.
Where the “relative importance” test doesn't give a clear answer, says IRS,
the “time” test comes into play. However, these tests may not clearly reveal
that any location is the taxpayer's principal place of business. In that
case, the taxpayer will be treated as not having a principal place of business.
Space
for storing inventory or product samples.
If you're in the business of selling products at retail or wholesale, and if
your home is your sole fixed business location, you can deduct home expenses
allocable to space that you use regularly to store inventory or product samples.
The space doesn't have to be used exclusively for business purposes. And you can
do business at the fixed locations of your customers (e.g., retail stores, if
you're a wholesaler), and non-fixed locations, such as flea markets or craft
shows.
Exclusive
and regular use requirements.
As noted above, when you claim to be using your home office under any of the
tests outlined above (except the “storage space” test for retailers and
wholesalers), the home office must be used exclusively and on a regular
basis in connection with your business. (For storage space used by retailers
or wholesalers, the space must be used regularly for business purposes, but
doesn't have to be used exclusively for those purposes.)
The
exclusive use requirement means that you must use your home office solely
for the purpose of carrying on your business. Any other use of the home
office will result in loss of all deductions for your home office expenses.
For
example, a professional musician's home studio that's used only for rehearsal,
recording demo tapes, etc., passes the exclusive use test. But a caterer's
living room that's used to meet with clients and potential clients, but is also
used for family entertainments and gatherings, won't pass the test. Neither will
a spare bedroom that's used to work on and store business records, but that's
also used to sleep occasional overnight guests.
The
regular basis requirement means that you must use the home office in carrying on
your business on a continuous, ongoing or recurring basis. Generally, this means
a few hours a week, every week. A few days a month, every month, may
do the trick. But occasional, “once-in-a-while” business use won't do.
We
can help you figure out whether your home office satisfies the exclusive and
regular use tests, and suggest things you might do to make sure that you do pass
these tests—for example, removing non-business furniture and fixtures, not
letting guests use your home office, keeping the kids out, etc.
What
you get if you qualify for home office deductions.
If your home office is your principal place of business under the rules noted
above, the costs of travelling between your home office and other work locations
in the same trade or business, regardless of whether the other work location is
regular or temporary, and regardless of its distance, are deductible
transportation expenses, rather than nondeductible commuting costs.
If
your use of your home office qualifies under any of the rules discussed above,
you may take business expense deductions for the following:
the “direct
expenses” of the home office—e.g., the costs of painting or repairing the
home office, depreciation deductions for furniture and fixtures used in the home
office, etc.; and
the “indirect”
expenses of maintaining the home office—e.g., the properly allocable share of
utility costs, depreciation, insurance, etc., for your home, as well as an
allocable share of mortgage interest, real estate taxes, and casualty losses.
Amount
limitations on home office deductions.
The amount you may deduct as home office expenses is subject to limitations
based on the income attributable to your use of the home office, your
residence-based deductions that aren't dependent on use of your home for
business (e.g., mortgage interest and real estate taxes), and your business
deductions that aren't attributable to your use of the home office.
Example:
Say you operate your business out of a home office that occupies 20% of the
space in your home. This year, your business grosses $50,000. The mortgage and
real estate taxes on your home total $20,000, $4,000 of which is allocable to
the home office. You have $5,000 of additional home office expenses
(depreciation, utilities, etc.). And your business has $30,000 of expenses that
aren't attributable to the use of your home office (secretarial and bookkeeping
services, legal and accounting fees, advertising expenses, etc.). To figure out
whether you can deduct your home office expenses, you first subtract the
home-office portion of the mortgage and real estate taxes, $4,000, from the
business's gross income. This leaves you with $46,000. Then, from this, you
subtract your business expenses that aren't attributable to your use of the home
office, $30,000. This leaves you $16,000. If this figure exceeds the amount of
your remaining home-office expenses, here $5,000, you can deduct all of those
expenses. If this figure is less than your remaining home-office expenses, your
deduction is limited. For example, if your remaining home-office expenses were
$25,000 instead of $5,000, you'd only be able to deduct $16,000 instead of the
full amount. And the computation gets even more difficult if your business
effectively earns money both in your home office and at other locations, because
the limitation formula only takes into account the income attributable to the
use of the home office.
Any
home office expenses that can't be deducted because of the above amount
limitations may be carried over and deducted in later years.
Computers
and related equipment.
If your use of your home office qualifies under any of the rules discussed
above, you may deduct the cost of computers and related equipment that you use
in the home office, and the deductions are not subject to the “listed
property” restrictions that would otherwise apply.
Effect
of home office deductions on later sales of your principal residence.
You should be aware that, if you claim any home office deductions with respect
to a portion of your principal residence, when you sell the residence, any
profit attributable to the portion used as a home office may not be eligible for
the otherwise available $250,000/$500,000 exclusion for gain on the sale of
principal residences.
We
can help.
Proper planning can be the key to nailing down the optimum tax treatment for
your office at home expenses. We are prepared to assist you with advice about
any of the issues discussed above. Please contact us if you would like to
discuss these (or any other) matters.
