Taking Your Business Home

The economic downturn has many businesses struggling to stay afloat. With so much at stake, some owners have moved their businesses into their homes to save money. If you are considering this option, then you need to be aware of the rules that apply when deducting home office expenses.

Generally, a self-employed individual will qualify for a home office deduction if the office is a place where the taxpayer meets with customers, patients or clients, or is used on an exclusive and regular basis for administrative or management activities of his or her trade or business, and there is no other fixed location of the business where the taxpayer conducts substantial administrative or management activities of the business. Even if a taxpayer conducts administrative activities at a fixed location outside the home, he or she is still eligible to claim a deduction as long as the administrative activities conducted at the outside location aren’t substantial. Space in the home used to store inventory for a wholesale or retail business also qualifies as business use of the home.

Deductible home office expenses fall under two basic categories: direct and indirect expenses. Expenses that are directly attributable to the home office, such as painting the office, repairs to the office space, etc., are 100% deductible to the business. The second category is indirect expenses that are attributable to the entire home, for which only a fraction of the total amount is allocated to the home. These include home mortgage interest, property taxes, insurance, certain utilities and depreciation. If the home is rented, substitute rent paid for interest, taxes and depreciation. The fraction used to allocate business portions of the indirect expenses is determined by dividing the business use square footage by the total square footage of the home.

The home office deduction is, however, limited to the gross income of the business derived from the use of the home for that business, and where the gross income is less than the expenses, certain expenses can be carried forward for the same trade or business in the subsequent years but cannot be used against a positive income from another business. Carryover never includes home interest, taxes and casualty losses because they are allowed without regard to the gross income limitation.

If the self-employed taxpayer owns the home, there is a negative aspect to the home office deduction that can create unexpected consequences when the home is sold. First, the allowable home office depreciation is never excludable under the $250,000 ($500,000 for joint filers) exclusion of gain for primary residences and will end up being recaptured as taxable income upon sale. Worse yet, if the office is located in a separate structure, then the home sale is treated as two sales, the sale of the home portion and a sale of the office portion. Any gain from the office portion would not qualify for the home gain exclusion and would be taxable.

For example, a married couple sells a home that includes a home office in a separate structure that is 20% of the total home square footage. The home, originally costing $150,000, is sold for $500,000. If the home office had never been claimed, or if the office had not been in a separate structure, the entire home gain, except recaptured depreciation, could be excluded from income. However, in this case, $70,000 (20% of the gain) becomes taxable income. (For this example, to keep it simple, we haven’t taken into account improvements, selling costs, or depreciation.)

If you would like to learn more about how the business use of your home might affect your taxes, please give this office a call.

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