Home Office Deductions

Computing the limitations on home office expenses.

by Tina Quinn and W. Terry Dancer

EXECUTIVE SUMMARY

In general, the home office must be used exclusively and regularly as the principal place of business or to meet and deal with customers in the normal course of the business. If the taxpayer is an employee, the home office must be maintained as a convenience to the employer. Whatever the area of the home office, it must not be used for any personal purposes. To qualify under the trade or business test, the area of the home must be used in connection with a trade or business, not merely a profit-seeking activity. The deduction is limited to income from home office activities, but any allowable excess deduction may be carried forward to future tax years, where it will again be subject to the income limitation. Expenses must be deducted in a specific order: mortgage interest, real estate taxes and qualifying casualty losses; direct expenses such as repairs to business equipment and supplies; insurance utilities and general repairs; and depreciation. Depreciation allowed or allowable may be subject to recapture when the home is sold or otherwise disposed of. The deductibility of a casualty loss depends on the property affected. If the loss is on the business portion, only it is a direct expense and the entire loss is includable. Tina Quinn, CPA, PhD, is chair and associate professor of the department of accounting & law, Arkansas State University in Jonesboro. Her e-mail address is tquinn@astate.edu. W. Terry Dancer, PhD, is associate professor, department of accounting & law, Arkansas State University. His e-mail address is dancer@astate.edu.

very year new technology makes working at home more feasible. The rising costs of commuting make it economical and the convenience factor makes it ever more attractive. As many as 51 million workers are likely to telecommute by 2008—about 14 million of them working from home full-time. Both self-employed and employee taxpayers may qualify for home office tax deductions, but the additional requirements for employees often are difficult to meet. Taxpayers and their CPAs need to be familiar with the requirements to maximize deductions and lower tax liability.

CRITERIA FOR DEDUCTION
Deductions for office-in-home expenses are available for qualified taxpayers, both self-employed and employees. To qualify for office-in-home deductions, taxpayers must meet the criteria provided by IRC section 280A. They must use part of the home

Exclusively and regularly as the principal place of business.

Exclusively and regularly as a place to meet or deal with patients, clients or customers in the normal course of the trade or business.

In the case of a separate structure that is not attached to the home, in connection with the trade or business.

Additional tests must be met if the taxpayer is an employee. In that case the office must be for the convenience of the employer and not for the convenience of the taxpayer. This is the most difficult rule to overcome. The taxpayer also must not rent to the employer any part of the home that he or she uses to perform services as an employee of that employer.

In Cadwallader, TC Memo 1989-356, the Tax Court found that the university provided adequate office space to professor Cadwallader and denied the home office deduction. The Seventh Circuit upheld the Tax Court’s decision. If the university had failed to supply Cadwallader with adequate office facilities, that would imply it expected him to maintain a suitable office at home. If he had used such an office exclusively and on a regular basis for his scholarly research and writing, he would be entitled to the home office deduction under IRC section 280A. But since the university provided him with adequate facilities on campus, the fact that he had chosen to work at home instead did not entitle him to take a deduction. In this situation the home office was not maintained for the convenience of the employer but for the convenience of the employee.

EXCLUSIVE AND REGULAR USE
To meet the exclusive use test, a taxpayer must have a specific part of the home—though not necessarily a complete room—set aside and used regularly and exclusively for business purposes. The area is not limited to a single room; multiple rooms may qualify. If the taxpayer uses an area of the home for both business and personal use, no deduction is allowed.

In Weightman, TC Memo 1981-301, the IRS disallowed a home office deduction for a taxpayer who used part of his bedroom as a home office. Although the amount was disallowed based on the exclusive rule, the Tax Court found that nothing in the law supported the idea that a home office must be an entire room or be physically separate from the remainder of the house.

The Tax Court confirmed that finding in Huang, TC Summary Opinion 2002-93, allowing the taxpayer a deduction for 75% of a room that was used exclusively for business, even though the entire room was not used for business purposes.

In Hughes, TC Memo 1981-140, the Tax Court ruled a home office could be located in what may be considered an unconventional place—a large walk-in closet—if all the rules were met for the space.

If the home office occupies only an area of the home, it’s important to segregate all personal activities from it. All the furniture and equipment must be confined to the specific home office area, not interspersed among personal items.

There are two exceptions to the exclusive use test. They are: when the taxpayer uses part of the home for the storage of inventory or product samples, or when the taxpayer uses part of the home as a day care facility.

To meet the regular use test, the taxpayer must use the specific area of the home on a regular basis—not only on incidental or limited occasions. Regular use does not imply daily use, but may require more than one use per month.

To qualify under the trade or business test, the area of the home must be used in connection with a trade or business, not merely a profit-seeking activity. For example, if a taxpayer is not a broker or dealer but merely making investments of his own, then a deduction is not allowed for the area used.

PRINCIPAL PLACE OF BUSINESS
The 1997 Tax Reduction Act (TRA) defines the phrase principal place of business as a place of business used for paperwork and management purposes and for other business activities if no other office space is available through the employer (section 280A(C)(1)).

If a taxpayer has more than one business location for a single trade or business, no deduction is allowed unless the home is the principal place of business, based on the relative importance of the activities performed and the amount of time spent at each location. To qualify as the principal place of business,

The area must be used exclusively and regularly for administrative or management activities of the trade or business.

The taxpayer must have no other fixed location to conduct those activities.

If the taxpayer uses the same area of the home as the principal place of business for two or more separate business activities, the home office must be the principal place of business for both businesses in order to be claimed a home office deduction; if only one activity qualifies under IRC section 280A, the home office expenses are not deductible (see Hamacher, 94 TC 348, 1990).

CALCULATING THE HOME OFFICE DEDUCTION
The order of deductibility of home office expenses depends on whether the expense is direct, indirect or unrelated. Direct expenses, those only for the business portion of the home, such as repairs to the ceiling, are deductible in full (subject to the gross income limit). Indirect expenses related to the entire home, such as mortgage interest, real estate taxes, insurance, utilities and depreciation, are deductible based on the percentage of the home used for business. Unrelated expenses, those only for the part of the home not used for business, are nondeductible. It is important for taxpayers to maintain accurate and complete accounting records, including receipts, in order to substantiate any deductions.

The home office deduction is limited to the income from the business; the only deductions allowed to increase a net loss are mortgage interest and real estate taxes. Any home office deductions not deductible in the current year may be carried forward indefinitely to future tax years, but still will be subject to the income limitation.

PRO RATA PROPORTION
Expenses related to the home itself—mortgage interest, real estate taxes, insurance and depreciation—must be prorated between the business and personal portions. There are two commonly used methods to determine the percentage of the home that is occupied by the home office. If the home office occupies an entire room (or rooms) and all the rooms in the house are about the same size, just divide the number of rooms used for business by the total number of rooms in the home. If the home office occupies a less well-defined area of the home, use the square footage method: Divide the square feet of heated and cooled space in the house used for business activities by the total square feet of space heated and cooled. Taxpayers are allowed to deduct depreciation based on the space used for the home office relative to the total space of the house.

EMPLOYEES WORKING AT HOME
If the taxpayer is an employee working at home for the convenience of the employer, he or she first must determine the home-office-deduction limitation, which is equal to the gross income from the business use of the home office. Then deduct

Mortgage interest, real estate taxes and qualifying casualty losses.
Direct expenses such as repairs to business equipment and supplies.
Charges for insurance, utilities and general repairs.
Depreciation.

Example. The following example was adapted from IRS publication 587 dealing with an employee working at home for the convenience of his employer, where the gross income from the home office=$6,000, the mortgage interest=$8,000, taxes=$4,000, insurance=$3,000, utilities=$3,000, direct expenses=$2,000 and depreciation=$5,000. The home office occupies 20% of the floor space.

For employees, most home office deductions are claimed on schedule A as miscellaneous itemized deductions subject to the 2% of adjusted gross income floor. Mortgage interest (100%) would be listed on line 10 or 11 of schedule A; real estate taxes (100%) would be listed on line 6 of schedule A; and any casualty loss would be listed on the appropriate line of schedule A. In the example above, the remaining home office expenses of $3,600 would be miscellaneous itemized deduction reduced by the 2% of AGI.

Self-employed taxpayers would compute the allowable deduction on form 8829. The order of deduction is the same for employees as for the self-employed. From form 8829, the total home office deduction (including the business portion of mortgage interest and real estate taxes) becomes a separate item reported on schedule C for the applicable business. The simplified C-EZ schedule may not be used for reporting any home office deductions. The 2% floor does not apply and the taxpayer may take the home office deduction even if he or she also takes the standard deduction.

OTHER DEDUCTIONS
If the home office is the principal location of a business activity, travel from the home office to another location is deductible. If the home has only one phone line, only the business long-distance expense is deductible.

The deductibility of a casualty loss depends on the property affected. If the loss is on the business portion of the home only, it is a direct expense and the entire loss is included in the home office deduction. A casualty loss to the entire home must be prorated to determine the deductible portion. A casualty loss unrelated to the home office is not deductible as a home office expense.

» Practical Tips

Segregate personal activities from the home office area. Move all home office furniture and equipment to one specific area. Maintain accurate and complete accounting records, including receipts.

SALE OF A HOME
In general, any depreciation allowed or allowable on the home office portion of the home is subject to recapture when the home is sold or otherwise disposed of. Taxpayers must adjust the basis of the home for any depreciation that was allowable for business use, but need not allocate the basis of the property and the amount realized between the business portion and the part used as a home. Taxpayers cannot exclude the part of the gain equal to any depreciation allowed or allowable after May 6, 1997.

Taxpayers do not need to report the sale of the business portion on form 4797. However, if the business portion was a separate structure, the sale must be treated as the sale of two properties. The basis and the amount realized must be allocated between the home and the business portion of the property and the sale of the business portion must be reported on form 4797. For more information see IRS Publication 523, Selling Your Home.

KNOW THE RULES
CPA tax advisers should be familiar with the rules for home office deductions and should be able to advise their clients on ways to maximize their deductions. Be sure clients maintain accurate and complete records, including receipts, to substantiate any deduction.