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Qualifying For The Home Office Deduction

by Broderick Perkins

The Internal Revenue Service recently gave work-at-home owners a break on the home-office deduction when they sell their home, but owners can't enjoy the home-office deduction without meeting a round of qualifications.

As long as your qualified home-based business is in the same dwelling as your primary residence -- rather than some unattached structure on your property -- you don't have to allocate a home sale's capital gains between the home and the business, according to "Exclusion Of Gain From Sale Or Exchange Of A Principal Residence," U.S. Department of Treasure Decision 9030, published Dec. 24, 2002 in the Federal Register, Vol. 67, No. 247.

That's a big switch from initial requirements set forth by the Taxpayer Relief Act of 1997. Law makers have been adjusting the landmark tax package since it was enacted more than a half decade ago.

(The law's most welcomed provision said when you sell your home, up to $500,000 of capital gains is excluded from federal taxes for married couples who file a joint tax return. Up to $250,000 is excluded for those filing separate or single-filer returns. You must have lived in your home as your primary residence for two of the past five years to qualify for the exclusion.)

"In the past, if you used 10 percent of your home for a home-based business, 10 percent of the gain on the sale would be subject to capital gain taxes and you couldn't use the exclusion on that portion," said Marie Sternberger, an enrolled agent from Sunnyvale, CA.

Now, provided you meet the primary residency and other requirements, even if you operate a business from your home, you are entitled to the full tax exclusion on capital gains realized from the sale of your home, according to the IRS.

The number of home-based businesses in the United States surpassed 20 million in 2002, and that number expected to be more than 25 million by 2003, with an average household income of more than $57,000 for homes with home-based businesses, according to the research firm International Data Corp. (IDC).

How to qualify

If you run a business from your home, along with business expenses, you can deduct part of your rent or take a depreciation deduction based on the portion of the home you use for business purposes.

Home-based business expenses (office, payroll, labor, auto, travel and entertainment expenses, business asset depreciation, supplies, items purchased for resale, etc.) reduce your net profit which in turn reduces your self-employment taxes and your income taxes.

For depreciation purposes, if your home is 2,000 square feet and you use 300 square feet as an office, for example, you can deduct 15 percent of your rent or take a depreciation deduction on 15 percent of your home.

To qualify for the deductions, the IRS requires that you pass three tests:

Your home must be your principal place of business. If you work from two locations, in order to take the deduction, the home must be the most important location, generally, the one where you generate revenue, but not always. If, you compare the two locations and it's not clear from which location you generate the most income, also consider time spent at either location. You must spend most of the time in the home for it to be the principal place of business under this consideration. If after you look at revenues and time and you still aren't clear if your home is the primary place of business, you probably shouldn't take the deduction, experts say.

There are two exceptions to this rule.

If your home office is not your principal place of business, you can take the home-office deduction if, for part of your business, you see clients, patients, or customers face-to-face in your home or use the space for administrative duties, paperwork activities and other related activities crucial to your business or work.

Also, if your home isn't your principal place of business but you use some free-standing structure on your property, exclusively and regularly for business, you can claim the home-office deduction for that space. A barn, greenhouse, workshop, studio, detached garage, any freestanding structure is eligible.

Remember, however, Treasury Decision 9030 will force you to allocate a home sale's capital gains between the home and your home-based business, if that business is not within the structure of the primary residence -- say, a detached garage, as opposed to an attached garage.

Your home business must also occupy a clear and identifiable space in your home. Generally, that means it must be in a location apart from the rest of your home, say, an addition constructed for your office, a converted bedroom, attic or basement, but also space in an alcove, nook or say, large walk-in closet space in a larger room.

You must use your home business space exclusively and regularly for your business. You can't use your business space, say, to watch TV with the kids, play computer games or temporarily house a visiting relative.

Published: January 17, 2003

Use of this article without permission is a violation of federal copyright laws.

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Broderick Perkins parlayed a career in old-school journalism into a contemporary digital news service that really hits home.

The award-winning consumer journalist, originally from Wilmington, DE, is founder, publisher and executive editor of the bootstrap DeadlineNews Group, a Silicon Valley-based editorial content and consulting service specializing in residential real estate, consumer news and related editorial consulting services.

The DeadlineNews Group includes the website, DeadlineNews.com, offering real estate editorial content and consulting services, and its back shop, the Deadline Newsroom, an open house on news that really hits home.

Perkins obtained his formal journalism education from University of Delaware and a journalism boot camp, the Institute of Journalism Education at the University of California-Berkeley. He went on to 20 years of service as a daily newspaper journalist at the Wilmington, DE News Journal and San Jose, CA Mercury News.

Perkins covered housing on the San Jose Mercury News reporting team which earned a General News Reporting Pulitzer Prize in 1989 for coverage of the Loma Prieta earthquake.

He has also produced real estate, consumer and small business content for the Wall Street Journal, Los Angeles Times, RealtyTimes.com, Nolo.com, Better Homes and Gardens, the National Association of Realtors, Homestore/Move and Intuit/Quicken among more than three dozen publications.

In addition to managing the DeadlineNews Group, Perkins most recently served as chief editorial consultant for Nolo's Essential Guide To Buying Your First Home, Nolo, and writes real estate television scripts for RealtyTimes.com.

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