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
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
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
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 taxpayers
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
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. Murphys 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 homes
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.
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).