Owning and operating a home-based business can be an exciting career choice, but one that can also come with many added financial responsibilities. One way to lighten the financial burden is to claim as many home office tax deductions as the IRS will allow. The savings will be significant and could make a big difference in the ultimate financial success of a small business.

Yet unfortunately for many, the tax laws regarding home office deductions are confusing and often misunderstood. As a result, most small business owners are not maximizing these deductions to their full potential and might not even be taking them at all. Having a clear understanding of what constitutes a “home office” is usually the most important step to receiving the many benefits claiming it can bring.

What does the IRS consider a home office?
The 1997 Taxpayer Relief Act says that as of 1999, any home office that is the business’s sole office and is used regularly for the administration of essential activities will qualify for a home office deduction. The main criteria the IRS currently uses is: 1) whether the portion of your home that you claim as a business expense is used both exclusively and regularly for business, and; 2) whether it is your principal place of business. Let’s examine these a bit closer.

Exclusive use means that the part of your home that you’re claiming is used only for business purposes and can be identified as such. That means that if you have a separate room where you perform your business duties and there is also a guest bed in that room, it will not qualify as “exclusive use.” Be sure to remove all non-business items from your home office space in order to qualify for this deduction.

There are two exceptions to this part of the criteria. If you are using a space in your home to store inventory on a regular basis for your business, you can take a deduction for that room, even if it is also used for non-business purposes. Likewise, if you are using space in your home as a day care facility for children, the handicapped, or the elderly and you meet the state’s licensing requirements, you may also take a deduction for any space used for that purpose.

Regular use means that the part of your home that you’re claiming is used regularly, or on a continuous basis, for your business. If the room you use as a home office is only used once every several months, the IRS would consider this “incidental or occasional use” and you would not qualify for a home office deduction. For the most part, this is a flexible criteria, and even seasonal businesses still qualify.

The principal place of business criteria has changed over the years, and with the recent passage of the 1997 Taxpayer Relief Act, a clearer definition has been established. Prior to the Act, the principal place of business was defined as the place where the most important functions of the business are performed or where meetings with customers or clients take place. Since then, the Act was created and now includes those who spend most of their time away from the office, such as people in sales or consultant positions. The new definition states that the principal place of business can now also be defined as the place where regular administrative duties are performed, regardless of where meetings take place or where the revenue is generated.

There are also two exceptions to this part of the criteria. If you have a home office in which you regularly meet clients, even if it is not considered your principal place of business, you still qualify for a deduction for that space. In addition, if you have a separate freestanding structure on your property that is not attached to your home but is still used exclusively and regularly for your business, you may also claim it for a home office deduction.

On a final note, if you are a salaried employee for a company and your employer requires you to work from home, you may also be eligible for a home office deduction. If your home office expenses are not reimbursed, they are deductible as long as they exceed two percent of your adjusted gross income.

A statement from your employer will likely be needed to support your claim.

What can be deducted once the home office criteria are met?
There are a number of direct and indirect expenses you can deduct as home office business expenses. These are in addition to the normal business deductions any small business, home-based or not, can take. They are:

• Rent, mortgage, and condominium association fees
• Repair and maintenance of the home office area
• Utilities used in the home office area
• A second phone line used for business, or long distance business charges on your primary phone line
• Trash collection
• Security system
• Household supplies used in the home office area

One thing to keep in mind is that the amount of home office expenses you deduct from your taxes cannot exceed the gross income you’ve earned from your home-based business. They can, however, zero each other out.

Are there any risks involved in claiming a home office deduction?
As long as you take the proper steps to ensure your home office is a legitimate one, you shouldn’t need to worry. Many believe that taking home office deductions increases one’s chances of an audit. This may or may not be true, but the IRS tends to look closely at the self-employed regardless, so you should definitely take any deductions you are entitled to.

There is, however, one drawback to claiming a portion of your home as a deduction. When you sell your home, if you have claimed part of it as a deduction, that portion will be taxed. For example, if you purchase your home for $100,000 and sell it for $120,000, the $20,000 increase in value will be subject to tax, which it normally wouldn’t if you hadn’t claimed a home office deduction. So if you claimed a 20% deduction, 20% of the $20,000, or $4,000, would be taxed upon the sale of your home.

As you can see, the tax laws concerning home office deductions can be tricky, but in essence, are not that hard to follow. If you are not sure if you meet the criteria or if you are still unclear on what you are allowed to legally deduct, be sure to call our office. You can also refer to IRS Publication 587 entitled Business Use of Your Home for instructions, examples, explanations and references on this subject. Just remember, being informed can help you save money and keep your business growing strong!

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