November, 2003 Tax Newsletter

Home Office Deductions Revisited

If you are a self-employed person who works from a home office, you can qualify for a home office deduction provided you use the office both regularly and exclusively for business.  This means you can’t use the office for any personal matters, such as managing personal finances or maintaining household accounts.

There are essentially four ways a home office could qualify for the deduction (assuming the regular and exclusive use tests are satisfied):

1) Your home office is your principal place of business. That means you physically do most of the work to earn your living in the confines of that office. If you are a freelance writer, a bookkeeper, or someone who uses a computer most of the day, you probably meet this requirement; or

2) You earn your living away from the home office (e.g. a painter or plumber) but your home office is exclusively dedicated to the paperwork and other administrative duties associated with your business; or

3) You use your home office to meet with clients; or

4) Your office is in a separate building from your home. For example, if your office is in a free-standing garage, you could get the tax break.

If you meet both eligibility criteria, the following deductions may be allowable:

All expenses related to the home office space-- including phone lines (which must be separate lines from the regular house line) as well as the cost of painting and cleaning the space and any premium you pay on a home-office rider on your insurance policy;

A percentage of the indirect expenses involved in your entire home (mortgage interest; property taxes; utilities; depreciation (if you are a home owner); maintenance; security monitoring fees; pest control, etc.). The amount is usually based on the square footage of your work area as a percentage of the total area of your living space. You should tally up only actual living space in your home when you figure out the percentage (patios, unfinished basements, etc. do not count).  Other “reasonable” methods of calculating your home office’s share of your home’s expenses are allowed (for example, 1 room out of 6 total rooms).

It should be noted that the home-office deduction is primarily intended for self-employed people.  In order for an employee to qualify for a home office deduction,  the work done at home must be for the convenience of the employer, not the employee.  Therefore, If you telecommute by choice you don’t qualify for the deduction.  An employee who seeks to take the deduction is advised to obtain a letter from his or her employer setting forth facts to establish that the work performed is for the employer's convenience.

Prior to around two years ago many taxpayers were reluctant to take home office deductions even if they qualified due to the risk of getting stuck with a tax bill for thousands of dollars if they sold the home.  That's because they were taxed on the appreciation of the office or business portion of the home. 

Under the current rules, you can take the depreciation deduction and all the other office-related deductions and your home office will generate no capital gains tax when it is sold.  The only exception is if your home office is in a separate building from the home.  You will have to pay a 25 percent recapture tax on the depreciation that was taken, but that is likely to be a small price to pay for the benefits you will have received.  Since most taxpayers with home offices are self-employed, paying a 15.3% self-employment tax can put their total federal tax at a very high rate.  Because the depreciation recapture is only 25 percent of the depreciation taken, it would certainly seem worthwhile to take the home-office deduction to reduce both income and self-employment taxes.

I would be happy to discuss the tax benefits of a home office deduction with you.