Home Office Deduction: An IRS Red Flag?
Last week I met with a new client who was eligible to claim a home office deduction but chose not to because she was afraid it would raise a red flag with the IRS and increase her chances of being audited. Is she right?
Well, IRS officials won't disclose details of how they pick which returns to audit or what percentage of those who claim the home-office deduction are audited. But it does appear that historically they have been very interested in this deduction, mostly because it has a fairly high adjustment rate on an audit.
Just because you work from home doesn’t mean you qualify to take this deduction. Since the rules are complex a lot of people claim the deduction when they shouldn’t, but according to this WSJ article many more of you are eligible but choose to pass on it.
Having said that, if you know the rules and do qualify, tax experts and other advisors say there is no reason to avoid it.
So if you are a sole proprietor (file a schedule C on your Form 1040) and have an office in your home, here is a breakdown of the rules. See below for some additional rules that apply to S corporation shareholders, partners and telecommuting employees.
Rule No. 1: “The home office is used for any trade or business.”
This one is easy. The office has to be used for a business. Investment, hobbies, not for profit and rental property management activities do not qualify as a business. Extreme couponing and reading investment magazines does not count.
Rule No. 2: “The part of your home used for business must be used exclusively for business.”
This is the one that gets most people. When the IRS says “exclusive”, they mean it. It’s a space that you use solely for your business, and nothing else. Almost any personal use for the area will disqualify you for the deduction. It doesn’t mean the area has to have four walls, just a designated space that is used exclusively for business.
I don’t make the rules just report them. I agree with you that the law has clearly not kept up with the reality of how people work. If you set up a comfortable home office with a nice computer, filing system, and workspace, you’ll probably do your personal work there like pay bills or play games. But the law does not allow for a proration of time based on how the office is used - for example by allowing you to deduct 80% of costs if you spend 80% of the time in your office working. It’s an all or nothing standard.
Here’s an example of how strictly they apply “exclusive”. In an example of how even minor personal use can destroy the deduction, look at Langer v Commissioner [TC Memo 1992-46]. Mrs. Langer ran a piano lesson business from her home and had a special area set aside for this exclusive purpose. However, during the year she had an open house allowing guests to use the room. The court ruled that this use violated the exclusive use test and Mrs. Langer lost her deduction.
Rule No. 3: “The part of your home used for business must be used on a regular basis for business.”
The IRS doesn’t offer a clear definition of regular use – only that you must use a part of your home for business on a continuing basis, not just for occasional or incidental business. You can probably meet this test by working a couple of days a week from home, or a few hours each day. On the other hand, two days a year would not constitute regular use.
Good recordkeeping is your get out of jail free card in this case. The burden of proof is on you in an audit.
Rule No. 4: “Your home office, studio or workshop must be your principal place of business.”
The principal place of business requirement is met if:
· You meet clients, customers or patients at home: Doing so even one or two days a week is probably sufficient.
· You use a separate building for your business: This might be a converted garage or barn for example. Just make sure you stick to the “exclusive use” rule and keep personal items out.
If you don’t meet these requirements, it’s not over yet. You can still qualify if both of the following are true:
· You conduct the administrative or management activities of your business from home.
· You have no other fixed location where you conduct those activities.
If you conduct your business only from home, then you meet both requirements.
Example 1: Jack is a self-employed contractor who builds single-family homes. He maintains an office at home, where he spends a significant amount of time working on building plans, ordering materials, calling subcontractors, doing payroll, keeping books, paying bills and conducting other administrative and managerial duties. The room is used for no other purpose. He can claim a deduction for having an office in his home because he uses the space exclusively and regularly to conduct administrative or management activities of his trade or business and no significant administrative or management activities are conducted elsewhere.
But what if you have a 2nd business location where you meet clients?
Example 2: Assume the same facts as Example 1, except that Jack also has an office in a high-rise building where he meets with clients, works on building plans, orders materials, meets subcontractors and performs other tasks directly related to the business of building houses. He continues to work at home doing payroll, keeping books, paying bills and conducting other administrative and managerial duties. He can claim a home office deduction because he uses the home office exclusively and regularly to conduct administrative or management activities and there is no other fixed location where he conducts substantial administrative or management activities.
Planning tip:
If you have an outside work location you may want to shift substantial administrative and management activities to your personal residence to qualify for the home office deduction.
IRS Publication 587, Business Use of Your Home, notes that administrative or managerial activities include (1) billing customers, clients or patients; (2) keeping books and records; (3) ordering supplies; (4) setting up appointments; and (5) forwarding orders or writing reports. It also gives several examples of activities that will not disqualify a taxpayer’s home office from being a principal place of business based on the administrative or management activities performed there.
Now that the hard part is over, it’s all downhill from here. We just gather the home expenses and complete Form 8829. Tax software makes calculating the deduction super easy.
How To File:
I know this is a lot so if you would like to discuss your specific home office question, feel free to call me. My contact information is on my website.
How To File:
Sole proprietors: Total allowable expenses on Form 8829 carry over to the bottom of Schedule C and reduce the net profit subject to self-employment tax.
S corporation shareholders: Prepare Form 8829 and submit to your corporation for reimbursement. The corporation gets the business deduction and you get a nontaxable reimbursement. If you itemize your deductions on Schedule A of your personal return, don’t forget to reduce your mortgage interest and real property taxes by the amount reimbursed you by the corporation.
Partners in a partnership: Partners are allowed to deduct unreimbursed ordinary and necessary expenses they paid on behalf of the partnership (including qualified expenses for the business use of your home) if they were required to pay these expenses under the partnership agreement. So first check the partnership agreement to see what it says about deducting a home office. If you can, then report the Form 8829 expense on Schedule E as an unreimbursed partnership expense.
Telecommuting employees: The law is not quite as generous for you guys. You must be working from home for your employer’s convenience. Let’s say you’re a virtual call center agent or data entry specialist and your company saves money on office space by hiring agents to work from home. In this case, you can deduct your home office space using Form 2106. However, if your employer lets you work from home because your commute is long (and the employer does have office space available for you), then you don’t qualify for the deduction. But then you make this far only to find out that you have to itemize take the deduction and it’s only good if it’s greater than 2% of my adjusted gross income. Forget it.
