Home Business Office Deduction
Many small business owners do a lot of paperwork at home. This year, there may be good news! Starting in 1999, it will be easier for taxpayers to deduct the cost of a home office. To qualify for a deduction, the office must be used exclusively and on a regular basis for either the entire business or just its administrative and management activities.
The "management" provision was added by the 1997 tax act. It enables a home office deduction to be available for any trade or business of the taxpayer as long as there is no other fixed location of the trade or business where the taxpayer conducts substantial administrative or management activities of the trade or business. The deduction is not harmed if some administrative or management activities (such as billing) are performed by others at other locations.
Even if the taxpayer also carries out administrative or management activities at sites that are not fixed locations of the business, such as a car or hotel room, the taxpayer's ability to claim a home office deduction is not affected as long as the activities are not "substantial."
In addition, a taxpayer's eligibility to claim a home office deduction will not be affected by the fact that the taxpayer conducts substantial nonadministrative or non-management business activities at a fixed location of the business outside the home (such as meeting with or providing services to customers, clients or patients at a fixed location of the business away from home.)
A home office deduction is comprised mainly of depreciation, utilities and insurance. For example, if a home has 2,500 square feet and the room used as an office is 250 square feet, then 10 percent of the utilities and insurance is deductible.
The office depreciation deduction is 10 percent of the amount that would be a depreciation deduction if the entire home were being depreciated for tax purposes. Supplies and other expenses directly related to the home office are fully deductible.
IRS publication 587, "Business Use of Your Home," is accessible from the Web at http://www.irs.ustreas.gov.
For specific advice, consult an accountant or tax attorney. The good news is that the "kinder and gentler" IRS has liberalized the rules for home office business tax deductions. The bad news is that the old rules still apply to 1998 tax returns; the new rules begin with the 1999 tax year.
Who can deduct home expenses as business deductions? For the 1998 tax year income tax returns, which are due by April 15, 1999, approximately 25 million self-employed renters and homeowners who work from their homes are potentially eligible. If you qualify, part of your home utilities, insurance, repairs, painting, property taxes, mortgage interest, and even depreciation of the home "business area" are tax deductible business expenses.
But the IRS loves to audit taxpayers who claim home business deductions. (my accountant has never let me claim a home office deduction...) To make the IRS audit job easier, new IRS Form 8829 is required for deducting a percentage of qualified home business expenses based on qualifying square footage used. No longer can taxpayers use room counts to determine deductible amounts.
The tough 1998 tax year tests for home business deductions. For the 1998 tax year, home business deductions are available if you either (1) meet patients, clients or customers at your home business location; and/or (2) use your residence as your principal business location. Unfortunately, in the 1993 case of Dr. Nadar Soliman (113 Sup.Ct. 701), the U.S. Supreme Court added two additional tests: (1) consideration of the taxpayer’s time spent at each business location and (2) review of the relative importance of the business functions performed at the home and other business locations.
The new, easier 1999 tax year tests. Fortunately, in the 1997 Tax Act, Congress changed these tough rules. Beginning Jan. 1, 1999, Internal Revenue Code 280A says a residence can qualify as a "principal place of business" when it is used to conduct administrative or management activities of a trade or business if there is no other fixed business location.
To illustrate, Dr. Soliman is an anesthesiologist who reads professional medical journals and handles management administrative work at his home office. But he administers anesthesia to his patients at several nearby hospitals. Beginning in 1999, he can deduct part of his home office expenses on his 1999 income tax returns. But he can't on his 1998 income tax returns.
Both old and new rules require an 'exclusive home business' area. Presuming you passed the home business use tests, your residence must then have an "exclusive business area" that is not also used for personal purposes. Part of a room can qualify if it is not also used for family or personal activities. For example, your desk and file cabinets in a portion of the family room can meet the "business area" test. Storage areas for products, such as Amway or Avon samples, also qualify, as does a separate business structure on your residential property.
A second business can qualify for deductions. Even if you work full time at a job elsewhere, your home business deductions for a second part-time business can qualify if you meet the above tests. The classic case is Dr. Edwin Murphy (73 T.C. 61), who was a full-time dermatologist working at a hospital. Dr. Murphy’s second, part-time job was managing his rental properties from his home office. The U.S. Tax Court approved his deductions, since he met the tests.
Employees must meet an additional 'convenience of the employer' test. If you are an employee, such as a computer operator or telemarketer, and your employer expects you to work from home, you can qualify for the home office deduction. Working at home must be for the "convenience of the employer," with no suitable work space provided by the employer.
Unfortunately, this additional test disqualifies many employees who simply prefer working from their homes. For instance, many schoolteachers prepare lesson plans and grade tests at home. If the school provides a suitable work area, the teacher cannot deduct home office expenses. However, if the school has no teacher work area, or the building is unsafe or locked after school hours, the teacher can then meet the "convenience of the employer" home office deduction test.
New rules for determining deductible amounts. In the past, qualified home office taxpayers could use any reasonable method to determine the percentage of deductible amounts. But IRS Form 8829 now only allows calculation of the deductible percentage based on business use square footage.
For example, if you have a 2,000-square-foot home and your qualified exclusive business area is 200 square feet, then 10 percent of your qualifying home expenses are deductible. If you are a renter, then 10 percent of your rent, plus other expenses, would qualify. This percentage applies to expenses shared with the residence, such as utilities and insurance. However, expenses that apply only to the business area, such as the business telephone line and painting/repairing the office area, are 100 percent tax deductible.
In addition, if you begin your business day at your home business location and use your car or truck for business, its business operating costs are deductible at 32.5 cents per mile for 1998 (or actual business expenses). This amount drops to 31 cents per mile as of April 1, 1999.
How to handle depreciation. The qualifying business area of your home can be depreciated using the 39-year straight-line depreciation method. The lower of your home’s adjusted cost basis or its market value on the day business use began can be depreciated proportionally.
However, the 1997 Tax Act says that when you profitably sell your principal residence, any depreciation deducted after May 6, 1997 must be "recaptured." In plain English, that means "taxed." Although there is no way to avoid this depreciation recapture at home sale time, if you expect to sell your principal residence, it's best to terminate your home business use a year prior to the sale. Then the profit on the sale of the former business area can qualify for the $250,000 principal residence home sale tax exemption. Otherwise, profit on the business area is taxable. Ask your tax advisor to explain further.
Tips
If you're planning to take a deduction for your home office in your rental unit, experts advise writing two separate rent checks -- one for the business portion or your rent (based on the percentage of space your office occupies), the other for personal. If the annual rent you pay on your home office exceeds $600, you are required to send a 1099 form (a "Miscellaneous Income" form) to your landlord for the portion of your rent that you will deduct. Another copy goes to the IRS.
Taking a photograph of the home office is also helpful for renters who plan to move -- proof that the home office in the old apartment did exist. For more information on tax requirements in setting up a home office, consult a free pamphlet put out by the IRS, "Business Use of Your Home," or "Home Office Deductions: Tax Kits for Individuals," published by CCH Inc. (call 800-835-5224 for ordering information).
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