Home-business use can produce valuable tax savings
A few years ago, I was audited by the IRS on my home-business tax deductions. The IRS sent out a field auditor to inspect my residence. Later, I learned when the IRS sends a field auditor, that means they think they can squeeze lots more money from the taxpayer.
As the auditor looked around my home, he noticed my home office occupied several rooms for my real estate rental and writing activities.
After about two hours of going over my business deductions at my dining room table, he said, "Your deductions are less than you should be claiming." Then he showed me several deductions I had overlooked. A few weeks later, I received a "no change" letter from the IRS, which is one of several I now have framed on my office wall.
How to deduct part of your home expenses. If you are one of the estimated 30 million taxpayers who use your home or rented residence for partial business use, you are entitled to deduct as "ordinary and necessary" business expenses a portion of the costs of operating your home.
For example, I recently paid my $1,218 annual homeowner's insurance premium. Based on IRS criteria for home-business deductions, I can deduct part of that normally personal, non-deductible expense as a business operating expense.
Whether you are employed and working at home for the convenience of your employer, such as a telephone sales representative, or you are self-employed, you may be entitled to home business tax deductions.
However, if you just bring work home from the office because you prefer working at home, then you aren't entitled to any deductions unless your employer doesn't provide suitable workspace.
To illustrate, suppose you are a schoolteacher. If your employer provides facilities to grade papers and other non-teaching work, you can't deduct home-business deductions just because you like to do that work at home. However, if you are told to leave the school after teaching hours, as are many city schoolteachers, then you may qualify for home-business tax deductions.
Special test for employees. If you are employed, such as an outside salesperson or service person expected to work from your home, the IRS imposes a special test.
Called the "convenience of the employer" test, it means your employer doesn't provide suitable workspace so you have no choice but to work from home. However, if you have an arrangement where your employer rents part of your home for your workspace, that won't qualify. In fact, you will then owe tax on the rental income.
Primary business location test for self-employees. If you operate a full- or part-time business from your residence, you can probably qualify for home business tax deductions as allowed by Internal Revenue Code 280A.
To qualify, you must be able to prove your residence is used either (1) to meet or deal with patients, clients or customers, or (2) you have no other fixed business location and your home is used for administrative activity.
A classic example is the 1993 U.S. Supreme Court decision involving Dr. Nader Soliman (113 Sup.Ct. 701). Dr. Soliman, an anesthesiologist, deducted part of his condominium home-office expenses because he spent many hours there handling administrative work and reading professional medical journals. However, most of his working hours were spent at several hospitals administering anesthesia to patients.
Although Dr. Soliman spent many business hours working at his home, the U.S. Supreme Court ruled he was not entitled to deduct his home-business office expenses because he spent most of his work time at the hospitals. In response to this decision, in 1999 Congress changed the tax law to allow self-employed taxpayers to deduct home-business expenses when their residence is their "primary business location."
The result is even if you don't meet business patients, clients, or customers at your home, you can deduct your home-business expenses if your residence is your principal business location even if you spend most of your time working elsewhere.
"Exclusive business area" is required. If you passed either the employee "convenience of the employer" or self-employed principal business location test, the next test requires having an "exclusive business area." It need not be a full room.
Part of a room can qualify if that area is where you have your business equipment and supplies. But it cannot be shared use. If you occasionally entertain business clients at home, that clearly won't qualify. Neither will use of your kitchen table to do your bookkeeping meet the test if you also eat family meals there.
Part-time home-business use can qualify. If you operate a part-time business from your home, such as selling Amway, Mary Kay or Avon products, you may qualify for the home-business tax break if you meet the exclusive-business-area test, such as for the area where you store inventory.
The leading U.S. Tax Court decision is Dr. Edwin Curphey (73 T.C. 61). He was a full-time dermatologist at a hospital. But he also managed his rental properties part-time from his home office. Dr. Curphey's exclusive home-business area met the residence-business deduction test although his property management work was part-time.
But part-time use of your home for investments won't qualify. The leading decision in the case of Joseph Moller (553 Fed.2d 1071) illustrates. Moller earned 98 percent of his income investing in stocks and bonds from his home. But the U.S. Court of Appeals ruled his home business was a passive, long-term investment rather than as an active "day trader" with frequent transactions.
Square footage determines home-business deductions. Whether you are a home business use "convenience of the employer" employee or a self-employed taxpayer using an exclusive home-business area, the amount of your deduction depends on the business square footage of your residence. IRS Form 8829 (Expenses for Business Use of Your Home) is the place to calculate your square footage and percent of home-business deductions. The former room count method is no longer available.
Some expenses are fully deductible. But 100 percent of some home-business expenses are deductible. All of your business-phone costs are deductible if you have a separate personal phone line. Computer broadband or DSL costs are also fully deductible for your business computer.
If you improve the exclusive business area, such as painting or renovating your home office area, the full cost is deductible as a business expense. Business insurance premiums are also fully deductible.
Depreciate your home. Homeowners can claim a depreciation deduction for the "exclusive business area" of their residences. For example, if your exclusive home-business area occupies 33 percent of your residence, then you can depreciate 33 percent of your home's purchase price (not including non-depreciable land value) on the 39-year commercial property straight-time depreciation schedule.
But when you sell your home at a profit, the 25 percent federal tax rate for depreciation recapture will apply. However, IRS Regulation 2002-142 says when selling your principal residence, even its "business area" can qualify for the $250,000 or $500,000 home sale tax exemption of Internal Revenue Code 121.
Home-business deductions can't create a tax loss. If your home-business tax deductions, when subtracted from the income of your home business, create a tax loss, that loss can't shelter your other income, such as interest and dividends.
Conclusion. Home-business use, whether full-time or part-time, can produce valuable tax savings. Both employees and self-employed taxpayers can qualify if they meet the tests. For full details, please consult your tax adviser.
Robert J. Bruss may be reached at 251 Park Road, Burlingame, CA 94010 or online at
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