Home Office Deductions: A Complex Business

Written by Posted On Sunday, 30 January 2005 16:00

Editor's Note: This column was originally published on January 26, 2004.

We have become a nation totally dependent on electronic devices -- whether they be computers, cell phones, wireless PDA's, facsimile machines or scanners. As a result, millions of Americans have opted to commute from their bedroom down the hall to their "home office," rather than face the stress and hazards of traffic, weather, and indeed, terrorism.

Now that tax time is upon us, the question then becomes: Can I deduct any portion of my home for this business use? After all, for every additional dollar that I can deduct for tax purposes, I can save (depending on my tax bracket) 25 to 35 cents.

As with any such tax question, we must start with the basic statute, which in this case is Section 280A of the Internal Revenue Code. That section starts out with the general rule:

Except as otherwise provided in this section, in the case of a taxpayer who is an individual or an S corporation, no deduction otherwise allowable ... shall be allowed with respect to the use of a dwelling unit which is used by the taxpayer during the taxable year as a residence.

But -- like most other sections of the Tax Code -- there are exceptions, exclusions and variations on the theme. Subsection (c) of this same Tax Code provision then goes on to provide for several exceptions to this rule. Specifically, your home office may be granted tax deductions if "a certain portion of the dwelling unit which is exclusively used on a regular basis:

  • Is the principal place of business for any trade or business of the taxpayer;

  • Is a place of business which is used by patients, clients, or customers in meeting or dealing with the taxpayer in the normal course of his trade or business, or

  • In the case of a separate structure which is not attached to the dwelling unit, in connection with the taxpayer's trade or business."

    Sounds relatively simple, but there are dozens of Court cases -- and hundreds of law journal articles -- attempting to explain all of the ramifications of this Home Office deduction. Let's look more carefully at the law.

    Exclusive Use: This is a mandatory requirement. In order to obtain the right to deduct your home office expenses, the portion of your home must be used only (i.e. exclusively) for your business purposes. According to the IRS, "the area used for business can be a room or other separately identifiable space. The space does not need to be marked off by a permanent partition. (IRS Publication 587, entitled Business Use of Your Home)

    The IRS provides the following example:

    You are an attorney and use a den in your home to write legal briefs and prepare clients' tax returns. Your family also uses the den for recreation. The den is not used exclusively in your profession, so you cannot claim a business deduction for its use.

    It should be noted that there are two exceptions to this requirement of exclusive use. If you use a portion of your home for a daycare facility -- or for the storage of inventory or product samples -- you do not have to meet the exclusive use test.

    Regular Use: Oversimplified, you may deduct a portion of your home expenses if the use of your business is on a continuing basis. According to the IRS, "you do not meet the test if your business use of the area is only occasional or incidental," even if the area is exclusive for your business.

    Business Use: Here is yet another legal requirement for a home-office deduction. In order to qualify, the use of that exclusive area in your home must be in connection with a trade or business. The IRS takes the position that if the only activities which are carried on in that exclusive area relate to your own financial investments (eg. you read financial journals and clip bond coupons), and you do not make investments or provide financial counseling for others, this does not meet the "trade or business" requirements of Section 280A.

    Principal Place of Business: This concept has been hotly debated over the years, and finally culminated in a United States Supreme Court decision in 1993 (Commissioner v Soliman). There, the Court held:

    There may be cases when there is no place of principal place of business, and the courts and the commissioner should not strain to conclude that a home office qualifies for the deduction simply because no other location seems to be the principal place. The taxpayer's house does not become a principal place of business by default.

    The case involved an anesthesiologist who practiced at three hospitals, and spent approximately 30 to 35 hours per week working at the hospitals. However, because the hospitals did not provide any office space, the taxpayer also established a home office in his apartment and spent approximately 10 to 15 hours per week performing administrative and educational business tasks directly related to his medical practice. When the case finally found its way up to the High Court, it upheld the position of the IRS and denied the deductions which the Doctor had taken for his home office. According to the Court -- and under the interpretations provided by the IRS -- the hospital was the "focal point" -- i.e. the principal place of business, and not the Doctor's home office.

    Congress reacted to this Court case. Recognizing that many Americans were, in fact, using their home for office purposes, section 280A was amended by adding the following language:

    ...the term "principal place of business" includes a place of business which is used by the taxpayer for the administrative or management activities of any trade or business of the taxpayer if there is no other fixed location of such trade or business where the taxpayer conducts substantial administrative or management activities of such trade or business.

    In other words, under the new law (which did not become effective until 1999), Dr. Solimon would have been able to take his home office deductions.

    What can you deduct: Assuming that you qualify for the deduction, you can deduct a portion of your mortgage interest, real estate taxes, insurance, utilities, repairs, security system and now even landscaping. Some of these expenses -- such as real estate taxes and mortgage interest -- are deductible whether or not you use your home for your business. However, many of the other items can only be deducted if you qualify as a home office under the tests outlined above.

    The simple way to determine how much you can deduct is to calculate the percentage of the house that is used for your business. Take the overall square footage of the area that is used for your business and divide it into the overall square footage of your house. The IRS provides the following example: If your house contains 1,200 square feet, and your home office is 400 square feet (12 x 20), your home office is 20 percent (240 / 1,200), and thus your business percentage is 20 percent.

    This discussion obviously is oversimplified, and if you maintain or operate a business from your home, you must seek advice from your tax advisors.

    Please also note the following:

  • If you only have one telephone line coming into your home, you cannot deduct the cost of basic local service, although additional charges for such items as long distance business calls, call-waiting or other business-related optional services can be deducted. A second line used for business purposes can be deducted.

  • If you are an employee who works at home, in addition to the requirements spelled out above, the law requires that the use of the home "must be for the convenience" of the employer. There is no definitive explanation or test for this requirement. According to the IRS, it depends on all of the facts and circumstances of your particular situation. For example, if the employer does not have adequate space in the principal place of business for the employee to do his/her job appropriately, then the home office deduction will be available. On the other hand, just because the employee prefers to work at home, that will not be considered as being for the "convenience" of the employer.

    NOTE: For many years, the IRS took the position that when you sell your principal residence, you would have to pay tax on the percentage of the profit that was attributed to a home office. In other words, that portion of the home used for business was not considered to be part of the principal residence.

    The IRS has now reversed their position. If you have lived in your house for two-out-of-the-five years before sale, you have the right to exclude up to $500,000 of the entire gain (if you are married and file a joint tax return, or $250,000 if you do not file a joint return). If within the last three years, you sold your principal residence but were required to pay tax on the percentage of your home office use, you should file an amended tax return and ask the IRS for a refund.

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    Benny L Kass

    Author of the weekly Housing Counsel column with The Washington Post for nearly 30 years, Benny Kass is the senior partner with the Washington, DC law firm of KASS LEGAL GROUP, PLLC and a specialist in such real estate legal areas as commercial and residential financing, closings, foreclosures and workouts.

    Mr. Kass is a Charter Member of the College of Community Association Attorneys, and has written extensively about community association issues. In addition, he is a life member of the National Conference of Commissioners on Uniform State Laws. In this capacity, he has been involved in the development of almost all of the Commission’s real estate laws, including the Uniform Common Interest Ownership Act which has been adopted in many states.


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