Home office deductions can save taxpayers a bundle if they meet the tax law qualifications. However, claiming expenses for a home office has long been a red flag for an IRS audit since many people don't qualify. But don't be afraid to take a home office deduction if you're entitled to it. You just need to pay close attention to the rules to ensure that you're eligible -- and that your recordkeeping is complete.
Beware: IRS Hot Button
The IRS often scrutinizes home office deductions claimed on tax returns. In one recent U.S. Tax Court case, many of the taxpayer's claimed expenses were disallowed once she became an employee. The case illustrates a number of issues that you should consider before deducting home office expenses.
Facts of the Case
Jean Marie Fontayne and her husband worked for Vitesse Semiconductor Sales Corporation. The husband was an employee, but Jean was a part-time independent contractor who worked from her home from January to July 2008.
After Jean's supervisor retired, his replacement hired Jean as a full-time employee in July 2008. As an employee, she was required to work from Vitesse's office at least two days a week and could work from home up to three days a week.
The taxpayers moved into their home in January 2008. Jean designated a room with a closet and a bathroom as her office space. Later that year, the taxpayers enlarged the home office. A contractor removed an office wall and replaced it 14 inches further into the living room.
In the home office area, the taxpayers replaced the carpet, re-tiled the bath, and added under-the-floor heating, a central vacuum, and a fireproof safe in the closet.
The Fontaynes reported a tentative profit from the business of $24,728 and expenses of $24,728 ($22,883 plus $1,845 for a casualty loss and depreciation) for business use of their home. That amount included direct expenses of $16,501 for repairs and maintenance, as well as an allocable portion of indirect expenses, such as utilities and homeowners insurance.
The taxpayers claimed that the office occupied 17.87 percent of their home (554 square feet in the home office divided by 3,100 feet in the total house). Their home office measurement included the hallway, entryway, room, bathroom and closet. In addition, the taxpayers calculated square footage from the outside of the house.
The IRS allowed deductions of just $1,113 for business use of home expenses. This included $391 of real estate taxes removed from Schedule A and re-characterized as home office expenses.
Tax Court Findings:
The court agreed that the taxpayers qualified for home office deductions for part of the year. The rest of the time, the court noted the taxpayer was an employee who wasn't required to work from home, although it might have made her more productive.
The taxpayers presented a letter from Vitesse stating Jean's part-time home office was beneficial for the company but wasn't required. Instead, she had to work at the company's location at least two days a week. The court ruled Jean didn't meet the "convenience of employer" requirement and disallowed home office deductions for the second half of the year.
The court also ruled the bathroom wasn't used exclusively and regularly for business. Neither was the closet, because Jean wasn't required to store inventory or other items for work. In addition, most of the claimed repairs were capital improvements which couldn't be deducted.
Ultimately, the Court allowed a home office deduction for the first half of the year when Jean was a contractor. The judge also scaled back on many of the taxpayers' computed direct and indirect expenses. (Fontayne, T.C. Summ. Op. 2013-54)
For Self-Employed Individuals
For self-employed individuals, a home office qualifies for deductions if it is used:
- Exclusively and regularly as your principal place of business;
- Exclusively and regularly as a place where you meet or deal with patients, clients, or customers in the normal course of your trade or business; or
- In the case of a separate structure, in connection with your trade or business.
There are also special rules for portions of a home used as a child care facility or for storage of inventory or product samples. If you are self employed, have no other business location and perform the work at home, you should qualify. You can also qualify if you perform administrative or management activities in a home office and have no other fixed location where you can conduct such activities.
For example, suppose you're self-employed and take orders while visiting clients. Your only location for processing orders and following up on inquiries is your home office, so it likely qualifies for a tax deduction. Regularly meeting customers or clients at a home office also qualifies it. The key word is regularly.
Seeing customers twice a month is unlikely to meet the threshold. The exclusive use requirement is also strictly interpreted. A spare bedroom converted into a home office will probably qualify, unless your relatives use the room when they come to visit.
The rules for employees are stricter. An employee's home office qualifies if it is:
- For the employer's convenience and
- Required as a condition of employment.
To be a condition of your employment means it is necessary for you to properly perform your work. For example, suppose you're an engineer who inspects construction sites during the day and performs administrative tasks at night. If your employer's office is locked after hours, your home office would probably qualify for home office deductions if you use it to write up daily reports. In these types of cases, get a letter from your employer to substantiate the facts.
Crunching the Numbers
When computing your deduction, there are two types of expenses that are deductible -- indirect and direct. Indirect expenses are those that pertain to the whole house, such as utilities and homeowners insurance. Those are apportioned based on the percentage of the space used for business.
Some expenses -- such as housekeeping and gardening expenses or repairs to another room in the house -- don't qualify as an indirect expense and would not be deductible at all.
Direct expenses don't have to be apportioned. For example, if you have a separate electric line and meter for your home office, the full amount of the electric bill for that meter would be deductible.
New Simplified Option
Starting in 2013, you can deduct a simplified safe harbor amount of $5 per square foot up to a maximum of $1,500 (300 square feet). That's not overly generous, but it means you can itemize your full mortgage interest and real estate taxes on Schedule A of your personal tax return.
In some parts of the country, the effective savings of the new simplified option may be as much as if you claimed actual home office expenses. But if you live near a major metropolitan area, the simplified option might amount to a fraction of the actual expenses.
Keep in mind, the simplified option only makes the recordkeeping burden easier. It does not change the criteria for who can claim home office deductions. There's no simplified method for qualifying in the first place.
Pick One Method for the Year
Below is a chart from the IRS comparing the two options for claiming home office expenses. Once you choose a method for the tax year, you cannot change to the other method for the same year. If you use the simplified method for one year and use the regular method for any subsequent year, you must calculate the depreciation deduction for the subsequent year using the appropriate optional depreciation table. This is true regardless of whether you used an optional depreciation table for the first year the property was used in business.
If you have questions about whether you qualify to claim home office deductions on your tax return, consult with your tax adviser.
New Simplified Option
Deduction for home office use of a portion of a residence allowed only if that portion is exclusively used on a regular basis for business purposes
The same rules apply
- Allowable square footage of business home use (not to exceed 300 square feet)
- Percentage of home used for business
- Standard $5 per square foot used to determine home business deduction
- Actual expenses determined and records maintained
- Home-related itemized deductions claimed in full on Schedule A
- Home-related itemized deductions apportioned between Schedule A and business Schedule C or F
- No depreciation deduction
- Depreciation deduction for portion of home used for business
- No recapture of depreciation upon sale of home
- Recapture of depreciation on gain upon sale of home
- Deduction cannot exceed gross income from business use of the home, less business expenses
The same rules apply
- Amount in excess of gross income limitation may not be carried over
- Amount in excess of gross income limitation may be carried over
- Loss carryover from use of regular method in prior year may not be claimed
- Loss carryover from use of regular method in prior year may be claimed if gross income test is met in current year