Tax Strategy for the Week (June 7th, 2013)

Home Office Tax Deduction

Tax Issue

Many small business owners have an office in the home. Under the general rule for business use of a home, no business deduction is allowed with respect to the use of a home that is used as a residence by the taxpayer. This is true even if the residence is used in the taxpayer’s trade or business. The general rule contains certain exceptions for business use and limitations on those deductions. One disadvantage to a home office is the specific requirements that must be met in order to claim a deduction for the business use of the home.

Applicable Tax Law

·        To take a business deduction for a home office, a taxpayer must use part of his or her home under one of the following situations.

–         An area in the home is exclusively and regularly used as the principal place of business.

–         An area in the home is exclusively and regularly used as a place where the taxpayer meets or deals with patients, clients, or customers in the normal course of a trade or business.

–         In the case of a separate structure which is not attached to the home, the structure is used in connection with a trade or business.

–         An area in the home is used on a regular basis for storage of inventory or product samples.

–         The home is used for a rental activity.

–          The home is used as a day care facility.

·        The exclusive use test is met if an area of the home is used only for business. The area can be a room or other separately identifiable space. The space does not need to be marked off  by a permanent partition. This test is not met if the taxpayer uses the area for both business and personal purposes. The exclusive use test does not need to be met for an area used for storage of inventory or samples or a home used as a day care facility.

·        The regular use test means a taxpayer must use a specific area of the home for business on a regular basis. Incidental or occasional business use is not regular use.

·        To satisfy the trade or business use test, the portion of the home used for business must be used in connection with a trade or business. If the business use is for a profit-seeking activity that is not a trade or business, the deduction is not allowed.

·        If the trade or business has more than one location, to qualify for a business use of home deduction, the home must be the principal place of business for that trade or business. To make this determination, the following are considered.

–         The relative importance of the activities performed at each place business is conducted, and

–         The amount of time spent at each place business is conducted.

·        Deductible home office expenses include real estate taxes, mortgage interest, homeowner’s insurance, rent, repairs and maintenance, security system, utilities, casualty losses, qualified mortgage insurance premiums, and depreciation.

·        Direct expenses include expenses that only benefit the area exclusively used for business and are fully deductible.

·        Indirect expenses include expenses for keeping up and running the entire home, such as insurance, utilities, and general repairs. Indirect expenses are deductible based on the percentage of the home used for business.

·        Unrelated expenses include expenses for the part of the home not used for business, such as lawn care or painting a room not used for business. Unrelated expenses are not deductible.

·        The percentage of the home used for business equals the area of the part of the home used for business divided by the area of the whole house. Any reasonable method may be used to determine business percentage.

 

Tax Planning Strategies

Running a business out of a qualified home office can turn nondeductible housing expenses into legitimate business deductions. If a home office qualifies as the principal place of business, a portion of otherwise nondeductible expenses, including utilities, insurance, home repairs, and depreciation, can become deductible business expenses. A qualified home office can also turn nondeductible commuting expenses into deductible business mileage.

 

Possible Risks

·        Any personal use of the home office will disqualify the home office under the exclusive use test even if the personal use is occasional or occurs in the evening after business hours.

·        When a taxpayer sells his or her primary residence, gain attributable to the office in the home portion of the residence is excludable under the rules for excluding the gain on the sale of a principal residence with the exception of the post May 6, 1997 depreciation.

·        The business use of home deduction is limited to the net income from the business with the exception of the business percentage of real estate taxes, mortgage interest, and casualty losses which are deductible even if there is a loss. All other business use of home expenses are limited to the net income from the business, and deductions not allowed are carried over to the following year.

·        Claiming an office-in-home deduction increase the risk of being audited.

 

Court Case:

A taxpayer was an employee for a hospital. In addition, he owned six rental units held for the production of income. The IRS denied the office-in-home deduction for the rental activity as it was not a trade or business. The court allowed the deduction and noted the personal efforts of the taxpayer to manage six units in seeking new tenants, in supplying furnishings, and in cleaning and otherwise preparing the units for new tenants. These activities were sufficiently systematic and continuous to place the taxpayer in the business of real estate rental. (Curphey, 73 T.C. No. 766, February 4, 1980)