Many home-based businesses consider the home office deduction one of the perks of working where you live. However, it may not be as easy to write off your home office as you might think. And, in many cases, it may not pay to take the deduction at all. For complete tax information about working at home, you might want to consult IRS Publication 587 -- "Business Use of Your Home".
In the meantime, investigate the questions below to learn more about what the home office deduction entails.
Am I eligible for the home office deduction?
If you work for yourself at home, you are eligible for a break on your taxes if your house, apartment or other living quarters is your "principal place of business".
You must also use your home office exclusively for business. This means you cannot work at the kitchen table or in a den that your family uses at night. There are a few exceptions to this rule, including day care centers, which tend to take over the house.
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How do I determine principal place of business?
The standard definition is "where you spend the majority of your time and make most of your money."
This means you have to earn the bulk of your income from your home office to qualify. If you sell at a client's office, perform the majority of your tasks outside the office, or go into the office for the majority of the week, you will most likely not be eligible.
Effective tax year 1999, the home office deduction is available for people who use their home office for substantial administrative or management activities. For example, a plumber who works in customers' homes for 30 hours a week, and does administrative work at a home office for 10 hours a week would be able to use the deduction under these changes. In order to qualify, you must still meet the principal place of business test, and you can not have another fixed location of business where you conduct substantial administrative or management activities.
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What can be deducted with the home office deduction?
If you are eligible for the home office tax break, deductions include a percentage of your rent or cost of owning your home, based on the square footage your office takes up (as a percent of your home). So if your office is 200 square feet and your home is 2,000 square feet, you can deduct 10% of your rent or home cost. You may also deduct the same percent of other home-related expenses, such as home insurance, utilities, cleaning service, repairs and maintenance, trash collection, etc.
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What about general business expenses?
Whether or not you qualify for the home office deduction, you can still deduct all business expenses that are not for the use of your home even if those expenses are for items used in the home or for expenses incurred in the home. They are deductible in full and not subject to the allocation rules for home office expenses. Here are some examples:
- Wages paid to employees who work for you from your home
- Business telephone expenses
- Depreciation of equipment used in the home office
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Are there any reasons why I may not want to take the home office deduction?
If you are upset because your home office does not qualify for the home office tax deduction, here's some good news for you. It's not always a good financial decision to take the home office deduction anyway.
The reason? If you are a home owner and plan to sell your house at some point, taking the home office tax deduction over the years may mean that you have some taxes to pay when you sell.
It works like this: When you sell your house there are usually significant tax advantages because you can defer tax on any gain as long as you roll the proceeds over into a new home of equal or greater value within 2 years. At age 55 you also become eligible for a one-time exclusion of up to $125,000 in gains as long as certain other conditions are met.
If, however, you run a business at home and take the home office deduction, you have turned part of your house into a business property. When you sell you will have to pay tax on at least some of the depreciation you've taken on the portion of the house the IRS now considers a business. This may be true even if you lose money on the sale of the house, unless the loss exceeds the depreciation.
Here's an example. Lets say you bought a house for $100,000 and sold it for $200,000. One-quarter of the house was used as a home office and was eligible for the home office deduction. When you sell you have a $100,000 gain, but the IRS sees it as a $75,000 personal gain, that you can defer by buying another home, and a $25,000 business gain that is immediately taxable.
Now for the depreciation kicker: For the purpose of this example, lets say you wrote off $15,000 of depreciation on the portion of the house that was devoted to your business over the years. You must add that $15,000 to your $25,000 gain and pay taxes on it. You now owe taxes on $40,000.
This is true no matter how small the gain or great the loss when you sell the house. If you have taken the home office deduction and gotten a tax break by depreciating the business portion of your home over the years, the IRS will demand that you pay taxes on the amount you depreciated when you sell.
The tax law logic is that you got a break over the years by deducting the depreciation on the property which would be fine if your house was actually worth that much less when you sell. Because you got a tax break over the years by declaring depreciation of your business property and will be receiving that money when you sell, the IRS wants you to pay tax on it.
Because of all this, some tax experts say the home office deduction is not worth it for many people. In the example above the taxpayer only saved about $200 annually.
You'll have to run the numbers for yourself and determine whether the home office deduction is worth your while. But when you're making the decision, you should factor in the reality that the home office deduction is a red flag for the IRS and makes an audit more likely.
Obviously if you rent and take the home office deduction none of this applies to you. Since you don't own, you don't depreciate. If you don't depreciate, you don't have this problem.
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Are there any other resources available to learn about the home office deduction?
"It's Not What You Make It's What You Keep! How to Keep as Much After-Tax Money As The Law Allows" by Julian Block (Prima Publishing, 1995)
A useful tax guide for small businesses and entrepreneurs.
Home Office Deduction Coalition
(1023 15th Street NW, 12th Floor, Washington, DC 20005; 202-466-2100)
Provides information on home office tax issues.
Recorded information on more than 100 tax topics.
IRS Publication #587 - Business Use of Your Home
(IRS Forms Distribution Center; 800-829-3676)
This IRS publication covers all tax information about working at home.
IRS Tax Information Line
For answers to general tax questions.
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