Home Office Still a Red Flag, but May Be Worth Risking

Editor's Note: Beginning Monday, Tracy Byrnes will answer your tax questions in Tax Forum each weekday through April 17. During that period, Saturday's columns will shift gears and focus on a single topic. Today, it's the home office deduction. As always, Tracy welcomes your questions. Send them, along with your full name, to [e-mail].

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Qualifying for the home office deduction is a bit easier this year, and that's good news for consultants, freelancers, entrepreneurs and anyone else who has decided to give up the corner office for a desk in the basement.

Previously, the deduction was reserved for workers who actually made their money in their home office, such as doctors or lawyers who see patients and clients at home. Salespeople, for example, couldn't take the deduction because their work was conducted primarily outside the home.

Now, workers who use their home office for administrative work may be eligible for the deduction, too. Those who qualify can deduct a portion of all expenses associated with that space, like the electric, heat and mortgage or rent payments.

But even though the rules have been loosened a bit, taking this deduction is still a red flag for an Internal Revenue Service audit. "Attaching a [home office deduction] form is increasing your audit risk, so make sure you're really entitled to it," warns Clarence Kehoe, partner and director of employee benefits at Anchin Block & Anchin, a New York accounting firm.

And keep all supporting documents, just in case questions arise.

You may qualify for a home office deduction if:	You can forget about the home office deduction if:
You go outside the home to see clients or customers but do paperwork at home.	You work in an office all day and work in your home office after hours.
You have no other office outside your home.	You work mainly from your employer's office but work from home office several days a week to be with the kids.
You're a trader.	You're an investor.
Your desk is in a room or in a partitioned space that is used exclusively for work.	Your desk is in the same room as the baby's crib.

No Kids Allowed

If you really think you're entitled to the deduction, take it. "Don't be afraid of it," says Maggie Doedtman, tax research and training specialist at H&R Block. But be aware that office means just that. It must be either a separate room that is off-limits to the rest of the family or a section of your house that is clearly partitioned off.

And it must be used regularly and exclusively for business. If your office desk is in the baby's room and doubles as a changing table, forget it. But if you put up a temporary wall that keeps the baby and the diapers out, you'll be OK -- as long as only work-related activities take place in this office. The kids can't play Pokemon on the computer, and you can't use your work email account to correspond with your college buddies.

Also remember that managing your personal assets is not a business. Even though you may spend hours in your office trying to uncover the next hot tech stock, investors can't take the home office deduction. Only traders can take the deduction. In fact, if you're a trader, you should take the deduction to solidify your claim to be a trader.

Not sure whether you're an investor or a trader? See this story from our Taxes for Traders series.

No Other Office Anywhere

Does your employer require you to have a home office? In IRS lingo, is the home office for the "convenience of your employer?" If so, you are eligible to take the deduction. Employees hired specifically to telecommute, for example, fall into this category.

You don't fall into this category if you bring work home from the office because you're a hard worker or you can't finish it during office hours. A teacher who grades papers at home can't take the deduction because, technically, she has a teacher's lounge at school. Parents who work two days a week from home to stay with the kids don't qualify, either. They have an office somewhere else and are working at home for their convenience, not their employers'.

Principles of 'Principal'

Your home office also must be your "principal place of business."

Fortunately, the definition of this term has changed. In previous tax years, if the home office was the place you made your money, only then could you take the deduction. So doctors and attorneys who practiced at home qualified, but salespeople, plumbers, landscapers and consultants -- those whose jobs took them outside the home -- did not.

Since January 1999, a home office could serve as the principal place of business for workers who don't have a fixed location in which to conduct managerial or administrative activities. Salespeople and consultants will now find it easier to qualify.

Deductions

Once you've gotten past eligibility issues, you need to determine which costs are deductible.

"You can deduct all the things that relate to that space," says Kehoe. That includes a portion of your electric and heat bills, trash removal, cleaning services and rent. (That's a big bonus because these costs are not normally deductible.) If you own your home, tack on a portion of your mortgage interest, taxes and depreciation.

How much of these expenses can you deduct? Divide the square footage of the office by the square footage of the house. If the office is 20% of your living space, you can deduct 20% of your rent, electric bill, etc.

If the rooms are about the same size, compare the number of rooms used for business with the total number of rooms in the house. If you have an office in a five-room house, one-fifth, or 20%, is used for business purposes.

If you run a daycare center, your percentage is calculated more generously. The IRS assumes the kids take over your entire house when you're watching them, so you can use the hours of your business to calculate the percentage of home expenses you can take.

For example, if parents drop children off at 6 a.m. and pick them up by 6 p.m., that's 12 hours a day, 60 hours a week. For 50 weeks a year, that's 3,000 hours. Divide that by the 8,760 hours in the year and you get 34%. So 34% of your rent, utilities, etc., can be included in your home office deduction.

Filling Out the Forms

If you are an employee required to maintain a home office, you'll report these unreimbursed costs on line 4 of Form 2106 -- Employee Business Expenses. The total will flow to line 20 of Schedule A -- Itemized Deductions. So your deduction will be limited to anything over 2% of your adjusted gross income.

Self-employed people will file Form 8829 -- Expenses for Business Use of Your Home. Part I of the form will help you determine the appropriate percentage of rent, utilities, etc., to be deducted.

In part 2, you'll find two columns, labeled direct expenses and indirect expenses. Direct expenses are those specifically for the office space. Remodeling the office is a direct expense. Rent, mortgage and utilities are indirect because they affect the whole living space, not just the office. The total from this form flows to Schedule C -- Profit or Loss from Business.

Check out Publication 587 - Business Use of Your Home (Including Use by Day-Care Providers) for more details.