Deductible Home Office - Do You Qualify?

To deduct the costs of a home-office, self-employed taxpayers must use the space exclusively and regularly as: (1) a principal place of business, (2) a place to meet or deal with clients and customers in the normal course of business, or (3) a place used in connection with a business if the space is a separate structure apart from the residence.

Employees can also claim home-office deductions. However, the business use of the home must be for the employer's convenience and the space must be used exclusively and regularly for job-related activities [IRC Sec. 280A(c)(1)].

Regular and Exclusive Use. Regular use means the taxpayer uses the home office space on a continuing (i.e., not temporary or occasional) basis.

Exclusive use means the taxpayer uses the space only for business purposes. There is no other use of the space, even after business hours. Two exceptions to the exclusive use rule are: (1) storing inventory (including product samples), and (2) certain daycare facilities.

Principal Place of Business Test. Of the three tests (principal place of business, meeting with clients/customers, and separate structure) for deducting a home office, the principal place of business test is most often used. The two primary factors for determining whether a home office is the taxpayer's principal place of business are the: (1) relative importance of the activities performed at each business location and (2) time spent at each place.

Generally, the "relative importance" test is applied first, and if no definitive conclusion can be reached, the "time" test is considered.

Administrative and Management Activities. Regardless of the "relative importance" and "time spent" tests, a home office qualifies as a principal place of business if it is used regularly to conduct administrative or management activities of a trade or business and is the only fixed location where substantial administrative or management activities are conducted [IRC Sec. 280A(c)(1)]. Administrative or managerial activities include (1) billing customers, (2) keeping books and records, (3) ordering supplies, (4) setting up appointments, and (5) forwarding orders or writing reports.

Calculating the Home-office Deduction

If a space qualifies as a home office, both direct and indirect expenses are deductible, subject to the income limitation discussed below. Direct expenses (e.g., repairs made to the room used for business) are all attributable to business. Expenses that benefit the entire home (e.g., utilities, insurance, interest, property taxes or depreciation) are deducted prorata based on the home office use relative to the total. Often, this allocation is based on square footage, but other methods may be used if more appropriate.

Caution: A portion of most utilities can be deducted if a home office qualifies for deduction. But, the basic charge (including taxes) for the first telephone line provided to a residence is always a personal expense [IRC Sec. 262(b)]. Business long distance charges related to this line plus the business portion of any additional lines to the residence should be deductible.

Net Income Limitation. Home-office deductions (with the exception of otherwise deductible items like mortgage interest and taxes) are limited to the business's net income [IRC Sec. 280A(c)(5)]. The limitation is applied by deducting the business-use portion of the home office expenses in the following order:
(1) expenses allowable as a deduction in any case (e.g., mortgage interest and property taxes), which are fully deductible even if they exceed the business's net income; (2) other expenses, except for depreciation; and (3) depreciation [Prop. Reg. 1.280A-2(i)(5)]. Excess expenses from categories 2. and 3. can be carried forward, but the net income limitation applies in each succeeding year.

Self-employed taxpayers deduct their expenses (including the business portion of expenses deductible regardless of the taxpayer's trade or business activities) "above the line." For employees, home-office deductions are generally itemized miscellaneous deductions, subject to the 2% of AGI floor. But, qualified residential interest and taxes aren't subject to the 2% of AGI limitation. However, the business portion of these expenses reduces the business income available for offset by other home-office deductions.

How a Deductible Home Office Affects the Home Sale Gain Exclusion

Generally, taxpayers can exclude up to $250,000 ($500,000 for joint filers) of gain on the sale of a principal residence used as such for at least 2 of the 5 years preceding the sale. This exclusion applies even if part of the dwelling was used as a deductible home office. However, the exclusion doesn't apply to a home office that's in a separate dwelling, nor does it apply to depreciation deductions for periods after 5/6/97 [IRC Sec. 121(d)(6)]. Instead, that depreciation (i.e., unrecaptured Section 1250 gain) is taxed (generally subject to a 25% maximum tax rate) to the extent gain is realized on the home's eventual sale. This applies to depreciation that is allowed or allowable. Gain can't be avoided by foregoing depreciation deductions [IRC Secs. 121(d)(6) and 1250(b)(3)]. Still, that's not a bad deal, considering the depreciation generated a benefit at the ordinary income rate, but is recaptured as income subject to a 25% maximum rate. And, that doesn't even consider the time value of money.

Example 3: James has used part of his home as a deductible office ever since he bought it 9 years ago. He has deducted $12,000 of post-5/6/97 depreciation on the home office. In 2004, he sells the home at a $150,000 gain. James meets the 2-out-of-5 year test for the part of his home not used as an office. Because the office is in the same dwelling unit as the residential portion of the home, James reports a single gain of $150,000, of which he excludes $138,000 ($150,000 - $12,000 unrecaptured Section 1250 gain, which is subject to a 25% maximum rate).