DO YOU USE A PORTION OF YOUR HOME FOR BUSINESS? If you do you may be able to deduct the expenses related to that portion of the home you use for business, including home mortgage interest, real estate taxes, repairs, utility bills and depreciation or home rental expense.

To be eligible to deduct the expenses associated with maintaining an office in or other business use of your home you generally must use the space exclusively and regularly (1) as your principal place of business, (2) as a place where you meet patients, clients or customers, or (3) in connection with your business if you are using a separate structure that is appurtenant to, but not attached to, your home. If you are an employee, your business use of your home must also be for the convenience of your employer. 

You may maintain an office in your home for use in performing administrative or management tasks related to a business you operate. In this situation, the home office is treated as your principal place of business if there is no other fixed location where you perform substantial administrative and management functions related to the business. If you use an area of your house for both business and personal purposes, it does not qualify for the home office deduction.

A special rule exists with regard to deduction of expenses related to a residential telephone. A deduction is not allowed for basic local telephone service charges on the first line in the home, however additional charges for long distance calls, equipment, optional services (caller ID, call waiting, etc.), or additional telephone lines may be deductible.

The business use of home deduction is limited to the gross income you receive from the activity less the deductible expenses without regard to business use. Thus you may not take a home office deduction to the extent it creates or increases a net loss in the business activity to which it relates. However, any disallowed deduction may be carried over to future taxable years.

Before deciding to deduct the expenses for the business use of your home, you should consider that this area has traditionally raised a red flag to the I.R.S., triggering examinations in many cases. Due in part to the fact that this was such a contentious area, in recent years the Supreme Court and Congress have acted to provide guidance to both taxpayers and the I.R.S. as to when business use of home expenses may be deducted, which is reflected in this Alert. You should be aware, however, that the I.R.S. may continue to test the limits of business use of home expense deductibility.

If you own your home you should also consider the effect of depreciation. If you qualify for the business use of home deduction, you will not be able to avoid future gain recognition by foregoing the depreciation deduction. This is important as, when you sell your home, presumably at a gain, the depreciation will be recaptured as ordinary income, whether you have deducted it or not. This may not be as bad as it sounds as you would be taking a current deduction which would not only reduce your income tax, but if you are self-employed it would also reduce the self-employment tax (which could be a significant amount).

If you own your home you should also consider that by taking a home office deduction you will not be able to exclude the entire amount of gain on the sale of your personal residence [currently limited to $250,000 ($500,000 if married filing jointly)]. Rather, you must recognize as capital gain the gain on that portion of the house used for business. Thus if you expect to sell your home at a gain, and especially if you do not plan to own your home for very long, you should consider foregoing the business use of home deduction entirely. You can use a "two on and three off" strategy whereby you use the office for personal purposes (thus disqualifying it for the business use of home deduction) for two years, followed by using the office exclusively for business for three years. Although you would lose two years of deduction, all of the gain on the business portion would be excluded from capital gain recognition. This is a particularly beneficial strategy if you are anticipating a large capital gain - the capital gain tax you would save should be significantly more than the taxes saved by taking the home office deduction for two years. If you have no intention of selling your principal residence in the foreseeable future you should not use the "two on and three off" strategy, but should take full advantage of the home office deduction until your plans may change, at which time you should consider using the office for personal purposes for at least two of the five years immediately preceding the sale of your personal residence. Note that you can be using the home office exclusively for business in the year of sale so long as you have used the home office for personal purposes for at least two of the five years immediately preceding the sale of your personal residence. A special provision also allows the exclusion of the gain on the business portion of your personal residence if you are forced to sell your principal residence because of a change in employment or health.

Please give us a call if you want to further explore whether you should be taking advantage of the business use of home deduction.
 

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