Home Office

Without question, a home office is one of the biggest resources for tax deductions to which you have access.  Unfortunately, many people don’t understand the wealth of tax savings they can qualify for with a home office because they have heard a few myths about the limitations placed on a home office. These  need clearing up:

Myth #1: I can’t claim a home office deduction because my house isn’t zoned commercially.
The truth is the IRS does not care at all about the zoning laws in your area.  You can live in a commercial, rural, residential, or agricultural zone and it won’t make a bit of difference to the IRS.

Myth #2: I can’t claim a home office because I don’t have a back entrance in my home.
The fact is that the IRS is not concerned about how many entrances you have in your house.

Myth #3:  My accountant said that the home office deductions aren’t worth the trouble.
Here’s what the numbers say, and these numbers are based on a $200,000 home: The value of an office in such a home is about $2,500 a year in cash, which if invested at 6 percent, makes the actual cash value of a home office (over a five-year period) worth almost $15,000 every five years!  In my opinion, paying yourself $15,000 every five years because you operate your business in your home sounds pretty worth the trouble, wouldn’t you agree?

Myth #4: My accountant says that the home office deduction is limited to my income so if I don’t make enough profit in my business, it isn’t worth taking it.
This is partly true.  Your home office deduction is indeed limited to the net income from your business after taking all your other business deductions.  Consequently, if you are not working your business, or if you are not making any kind of substantial income, you do not get an immediate benefit.

However, no “immediate benefit” is not the same as no benefit at all.  If your deduction exceeds your net income from your business, you can carry it over into future income years indefinitely.  So, as you make more money, you can offset those nice increases in income with carry-over deductions.

As you can see, a home office can be a very legitimate tax deduction.

Strategy – If you are eligible for a home office deduction, take it!
Here’s how to assess whether you can apply this strategy:
The law states that a home office deduction is available only to the extent that a portion of the dwelling unit is used exclusively and on a regular basis.  This means that your home office must be:

1. Your principal place of business; and/or
2. The place of business where you meet and greet customers,
3. Used for a second business you have; and/or
4. Used to display sample products or as a storage space for inventory.

In addition, if you are using an office in your home to do work as a regular W-2 employee, then the home office deduction is allowed only if the exclusive use of the office is for the convenience of your employer.  Thus, your employer must require you to take work home and not provide you with an office at work.

Let’s examine each of the criteria I have outlined above in more detail:

Criteria #1:  Principal Place of Business.
There are two tests used to determine whether a home property is a principal place of business for a home office:

Test #1: “Where do you do your most important functions?”
Your primary function does not necessarily have to take place in your home office as long as your office at home is used to conduct the administrative or management activities of your business AND you have no other office where you can conduct such activities.  Thus, if you keep your logs do your paperwork, listen to training CD’s, make business calls, create business materials, etc., and out of a set place in your home, you will be legally eligible for the home office deduction.

Test #2: Do you use your home office for more than 50 percent of your at-work time?
The way this test is worded can be a bit misleading.  What Test #2 is actually saying is “do you perform any significant services in another office?”  If you don’t, you qualify.
If you keep good records and work the 50 percent required time in your home in order to operate your side business, you will have no problem taking the home office deduction.  Moreover, even if you don’t meet the 50 percent test, if you conduct your significant administrative activities for your business at home and don’t have another office where you can conduct those activities, then your home constitutes a “principal office” for purposes of the home office deduction.

Criteria #2:  Meet-and-Greet Test.
If you don’t use your home office 50 percent of the time for your home-based business and don’t meet the exceptions I have just listed, you can still qualify for the home office deduction when you use your home as a place where you meet and greet your clients (customers, patients, distributors, and so on) as a regular and ongoing part of your business.  Such use must be substantial and integral to conducting your business.
During an audit, the IRS will look very closely at your actual physical meeting with clientele or customers.  Telephone contacts do not count no matter how lengthy or frequent.  Meeting and dealing with clients in your home office is what counts.  Now-and-then meetings do not qualify.  The law requires that:

• Meetings occur in a planned way.
• Such meetings are ordinary (or regular).
• Such meetings are an essential part of the way you carry on your business.

Be sure to keep track of all your hours for these meetings.  Every time you work, you should note in your tax diary what you are doing.  When you see clients, you should note this in your diary.

Criteria #3:  Home Office Deduction for a Second Business.
You might be able to qualify for a home office deduction in yet another way.  If you happen to have a second side business, you can claim a home office deduction for that as well.  The deduction does not have to relate to your primary business.

Criteria #4:  Display or Inventory Storage.
If you use space in your home to display or store products that you sell on a wholesale or retail basis, you can add the square footage of this space to the space you claim for the home office deduction.

One of the requirements however, is that your residence be the sole fixed location for your business.  My recommendation, in order to help you meet these criteria is to take photographs of the location in your home where you store inventory or display product samples.  This is vital.  By doing so, the IRS will have proof that you are using the space in this manner and cannot question you.
If you can meet any of the above criteria you will have no problem proving that you use your home to conduct business and can take the home office deduction.  Once you decide to take it, you should be aware of a few rules that can help you substantiate your claim.

You must use a room, or portion of a room, exclusively and regularly in one of several business functions in order to take a home office deduction.  When the IRS says “exclusively,” it’s not kidding.  This means that no personal or other non-qualifying work activities may occur in your home office area.  If you watch TV in the designated home office area, unless it’s solely for training/business purposes, remove the television.  Remove books that are unrelated to your work from the shelves in your office work space, and remove the games and other family fun activities out of the area.

To qualify for the home office deduction, you don’t have to use an entire room as your workspace.  If you want to use part of the room for business you can do that.  However, there should be some physical separation of the business area from the personal area.
If you keep your desk, chair and filing cabinet in your living room, for instance (which is the way many home-based businesses start out), then the square footage those items occupy qualifies for the home office; the rest of the room’s square footage does not.  You are not allowed to co-mingle your business and personal furniture.

I often hear people wondering if the IRS will really send someone over to their house to see if they are using an exclusive portion of a room for business.  Yes it will.  Fortunately, if it plans to send anyone by your house it will give between four and twelve weeks advance notice.  Even with a notice however, the IRS still manages to nail the unsuspecting taxpayer.

So how can you absolutely with confidence, prove a home office deduction?  Follow these strategies and you will be totally secure:

Strategy – Photograph Your Office.
A photo can be a very important piece of documentation.  Take pictures of the bookshelves, the file cabinets, the desk, and the general workspace.  Make sure you have all your personal items out of the area before you do so.  You don’t want the IRS to see your “Crossword Puzzle Secrets” book (for example) in the photograph.  Date the photos, but don’t send them to the IRS.

Simply hold onto them in case you ever do get audited.  They will come in very handy.  Photographs establish exclusivity.

Strategy – Prepare a Floor Plan.
Keep blueprints of your home to prove the amount of space occupied by the home office.  If blueprints are not available, make a drawing of your home showing the relationship of the home office’s square footage of the home.  Using a floor plan with the actual square footage of your home, you can easily calculate how much square footage you can deduct for a home office.

Strategy – Prominently Display Home Office Address.
Put your address and telephone number on business cards and stationery.  The IRS takes the position that if people don’t know you’re alive and kicking somewhere, you can’t take a home office deduction.

Strategy – Use a Guest Log.
If you physically meet and greet clients at home on a regular basis, you can absolutely prove your home office exists using a guest log. Every time clients come to your home, have them write down their name, address and occupation.

Strategy – Document Use of Your Office in Your Tax Journal.
This is where a tax journal can pay for itself a hundredfold.  Use your tax diary to record what activities you performed in your home office such as, “researched marketing strategies from 8 a.m. to 9 a.m.,” or “made calls from 9 a.m. to 12 p.m., HO (Home Office).”

This work activity log in your journal does not need to be an elaborate document; simply keep notes about what you did during the day.  If you ever get audited, you may have to answer questions about work or phone calls or training sessions that occurred two or three years prior.

When you make long distance calls, are you required to write down every person’s name that you call in your tax diary.  Generally not, but you should log it somewhere as a business-related call.

During an audit, the IRS would ask, “Is this particular activity business or personal?  “If you have not kept a log of your daily business activities, how will you ever know?  You can look at your phone bill from three years previous and not be able to discern what calls were made for business and what were made for pleasure.  Don’t forget the IRS, if it audits you, in most cases, will not be doing so, the same year you made those calls.
Remember, keep a good tax diary and organize all records.
Here are a few final things to consider…:

If you are eligible for a home office deduction, you have to claim it.  You cannot simply decide not to deduct it if you do meet the eligibility requirements I have outlined above.  Why is this?

Because if the IRS discovers that you are eligible, they will insist that you have to reduce the basis of your home by the amount of depreciation allowable anyway, so you might as well take it.

If you rent, you must take the claim by deducting a portion of your rent as it equates to the square footage of the home office.  For example, if you pay $750 per month in rent on a 1,000 square foot apartment, and your home office occupies 250 square feet of that space, you can deduct one fourth of your rent (or $187.50 per month; $2,250 per year) for your home office.

Another thing to consider is that the home office deduction is limited to the net income from the business activity you conduct at home.  Consequently, if you have any expenses above and beyond the net income, you will not be able to deduct those home office expenses.  However, that doesn’t mean you shouldn’t take the home office deduction.  Any expenses disallowed solely because they exceed your business income can be carried forward until you have sufficient income from your business conducted from home.

Strategy – Determine whether or not you qualify to take the home office deduction.
An “Office” qualifies as a home office if it’s located in any of the following: a house, apartment, mobile home, boat, or even some structures that are unattached to your main dwelling, such as a garage, greenhouse, studio, barn, etc.
By way of review, in order to qualify for a tax deduction, your home office must be used “regularly” and “exclusively” under the following conditions:

1. As a principal place of business
2. As a place where you meet with customers in the normal course of business – if this activity is required by your business and,
3. As a place where income-generating activity takes place.

For example, if you are in the business of doing bookkeeping for other businesses, and use a home office in providing the service, you would be entitled to a home office deduction; however, if you bring home bookkeeping work for your business and do the work in a “Home Office”, you would not be entitled to a home office tax deduction.

Home office expenses fall into two (2) distinct categories:

1.  Direct Expenses: These are expenses that benefit only the business part of your home; they can be deducted in full–they do not have to be prorated using a percentage of business usage figures.
For example: painting and repairs made to the specific room, plus any special feature charges on your telephone bill – such as call forwarding, call waiting and conference calls.

2.  Indirect Expenses: These include expenses for upkeep and running of your entire home.  Since they benefit both the personal and business parts of your home, you must apply the business usage percentage to these before deducting them – For example: rent, 2nd telephone line base charges, deductible mortgage interest and real estate taxes, repairs, maintenance, security system, cleaning, and home-related insurance premiums.
Strategy – Identify these “Home-Related” expenses that qualify as home office tax deductions, and determine their dollar value:

1.   Direct Expenses:

• Painting (specific room)
• Repairs (specific room)
• Special Telephone features
• Total (tax deductible) Direct Expenses

2.   Indirect Expenses:

• Rent
• Deductible mortgage interest
• Real Estate taxes
• Repairs (General Home)
• Maintenance
• Security System
• Cleaning
• Home-related insurance premiums Total Indirect Expenses

Strategy – Calculate your “Home Office Percentage”:  The percentage of your home expenses that qualify for the home office deduction.

There are four steps in the process of determining this percentage:

Step #1:
Determine the total square footage of your home. This can be accomplished in any of the following ways:

1. County property tax rolls,
2. Outside dimensions of your house,
3. Square footage of each room in your house, or
4. A purchase agreement (when you bought your house– if applicable)

Step #2:
Measure the square footage of the room you have established as your home office.

Step #3:
Divide the square footage applicable to your home office by the total square footage of your home. This is your “Home Office Percentage” (the percentage of the total square footage of your home that is applicable to your home office.)
For example: if the total square footage of your home equals 2,000 square feet, and the square footage applicable to your home office equals 200 square feet, the percentage of your home that is applicable to your home office is 200 divided by 2,000 = 10%.

Step #4:
Use this percentage to determine the dollar amount of your home expenses that may be deducted.  In the above example, you would be able to deduct 10% of your home expenses.

Strategy – Calculate the allowable home office depreciation expense applicable to the cost of the home office “Structure only” (Excluding any land cost).
Note: You must own your home to qualify for any home office structure-related depreciation expense.

The following steps can be used to determine the total “Deductible Depreciation Expense” for your home office:

Step #l:
Determine the “unadjusted basis” of your home by:
Adding the cost of your home (less) the cost of the land to any permanent improvements you have made since you bought it.  Then subtract any casualty losses you had deducted on your tax return in earlier years.  Then subtract the “Unadjusted Basis” of your home.
Note: If you change part of your home from personal use, the unadjusted basis of your home for depreciation purposes is the lesser of:  The unadjusted basis of your home shown above or the fair market value of your home (less the value of any land).

Step #2:
Determine the adjusted basis of your home by multiplying the “unadjusted basis of your home” by the percentage of business use applicable to the home office portion of your home:

The unadjusted basis of your home multiplied by the “Home Office Percentage” (the Percentage of business use applicable to your home office) equals the “Adjusted basis of your home office”.

Step #3:
Calculate the depreciation expense allowable for your home office. You should use depreciation rates under the “Modified Accelerated Cost Recovery System” (MACRS) for nonresidential real property straight line method over 31.5 years (3.175 % per year).
(For property placed in service after May 12, 1993, (MACRS) nonresidential real property may be depreciated using the straight line method over 39 years (2.56 % per year).

To calculate the depreciation expense allowable for your home office:  multiply the Adjusted Basis of your home by the Applicable Depreciation Rate.  Then subtract the Total Deductible Depreciation Expense.

Note: The tax deductions determined in Step #3 above do not include the following tax deductible expenses:

1. Office supplies.
2. Long-distance telephone calls and/or a second telephone line, dedicated for business usage only, or
3. Depreciation expense associated with business equipment you use in your home office.  In fact, you can deduct any depreciation expense applicable to equipment used in your home office – even if your office fails to qualify as a deductible home office.

Strategy – Calculate your business grand total tax deductible “Home Office” expenses:
To calculate your deductible Home-Related Expenses, multiply either:

1. Tax Deductible “Direct Expenses” or
2. “Indirect Expenses” by the Home Office Percentage, this equals your Tax Deductible Direct or Indirect Expenses.

You can Calculate Home-Structure Related Expenses by:
Multiplying the Unadjusted basis of your home by your Home Office percentage, this equals the adjusted basis of your home.  The adjusted basis of your home multiplied by the Applicable Depreciation Rate equals your Total Home-Structure Related Tax Deductible Expenses.  By adding your total home related expenses and your total home structure related tax deductible expenses together, this will give you your Grand Total Tax Deductible “Home Office” Expenses.

Strategy – Maximize your home office deduction.
If your business is a sole proprietorship; take as much in home office deductions as is allowed, and accumulate the excess for a later tax year.

Your business is only entitled to home office business deductions for a given year to the extent of the business profit for that year; home business deductions cannot be used to create a “Tax Loss” for your business.

However the business can carry over any accumulated “home office expenses” – not deducted in the current year, to be used as home office deductions in future tax years, when your business does show a profit.

If your business is a Corporation, reimburse yourself personally for the home office deduction.

If your business is a corporation (either a “C” or an “S”) you are considered to be an employee of that corporation, as well as an owner, and therefore you are not entitled to a business home office deduction.

Your corporation should write you a reimbursement check, periodically (monthly or quarterly) for the allocatable home office portion of the taxes, interest, depreciation, repairs, utilities, etc.. This gives your business a tax deduction equal to the reimbursement check, yet you receive the reimbursement dollars “tax free” since your home office deductions equal the reimbursement

Use a basis adjustment to defer paying income tax on the sale of your home.
If you operated your business as a Sole Proprietorship, and you took depreciation expense on your home office, you are eligible to adjust the basis of your home on the date of the sale of your home by the cumulative amount of depreciation expense taken and thereby defer income tax liability on the amount of this depreciation allowed.

Note: And if you roll forward this accumulated gain – by purchasing another house of equal or greater value within two years, you can avoid any tax liability by taking your one-time exemption from capital gains on your personal residence.)
Take a tax deduction for business equipment used in your home office, even if you don’t qualify to claim a home office deduction.  Equipment that is used in your business, in pursuit of generating sales dollars, is fully deductible as a business expense.

This is true even if your home office fails to qualify as a “Tax Deductible” home office.  If you wish to use a home office, you should do so, even if it isn’t tax deductible, and be certain that you deduct any and all business equipment used in your home office.
If you’ll apply these strategies, you’ll be able to save a substantial amount of money on your taxes each year.  Money which when immediately added to your savings and will greatly increase the speed in which you will be able to become both debt free and financially free.

Enjoy the savings!