Home Office Deduction Challenges You Should Know
Tuesday, 31 March 2009
If you are planning to take a home-office deduction on your tax return this year, consider carefully the advantages and disadvantages. This deduction has an interesting and often conflicting history.
Tax Court Ruling 1990
In 1990, the U.S. Tax Court ruled that if “a taxpayer’s home office is essential to his business, he spends substantial time there, and has no other location available to perform the office functions of the business,” the taxpayer is entitled to a deduction.
The case the Tax Court ruled on involved a Washington, D.C. area anesthesiologist, Nader E. Soliman, who practiced at three hospitals but who had office space at none of them. He spent a third of his time at his home office doing billing, arranging hospital admissions, maintaining financial and medical records and keeping up on his professional reading. The Tax Court felt he was justified in writing off his office since it was essential to his practice.
The ruling liberalized the old, so-called “focal-point test,” which forced the taxpayer to show that the home office was the focal point of his or her business. Under the focal-point test, the room set aside in the home had to be used exclusively and regularly as a principal place of business, or as the place where the taxpayer met clients.
None of this sat well with the Internal Revenue Service (IRS). They appealed the Soliman decision all the way to the Supreme Court, and won a reversal.
Taxpayer Relief Act 1997
The Taxpayer Relief Act of 1997 eased requirements for deducting expenses of a home office, effective starting with 1999. To qualify as a home office today it must be “a principal place of business”.
Outside Offices
Under the new rules, you may qualify to claim the deduction, even if you never qualified before.
Beginning in 1999, it became easier for your home office to qualify as your principal place of business. Your home office will qualify as your principal place of business for deducting expenses for its use if you meet the following requirements.
- You use it exclusively and regularly for administrative or management activities of your trade or business
- You have no other fixed location where you conduct substantial administrative or management activities of your trade or business
If you are an employee, the business use of your home must be for the convenience of your employer. The limitation of your deduction may be less if your gross income from the business use of your home is less than your total business exp
Pros & Cons
The advantages of a home office are the availability of certain “above the line” deductions that would either ordinarily be personal and unallowable, or if business, subject to 2% of Adjusted Gross Income (as an employee). Other advantages are an increased transportation deduction, a reduction of Self Employment tax and a reduction of Adjusted Gross Income resulting in increased deductions dependant on a percentage of AGI floor (medical, casualties, miscellaneous deductions, etc.).
Disadvantages include part of the home sale exclusion becoming subject to capital gains, and reduced benefits from retirement plans and social security.
The advantages and disadvantages must be weighed to determine the greatest tax advantage, i.e., will home office deductions (including an increased transportation deduction), taken over a number of years, reduce taxes more than the increase caused by capital gains tax on the office part of the residence.
In many instances the transportation deduction, computed from the home office to the customer or clients’ place of business, is the major advantage of having a home office. Consider a very small home office, i.e., a very small percentage of the home sale deduction lost, and still retain the ability to deduct transportation costs.
If you plan in advance to sell your residence you can terminate your home office for the final two years before sale and meet the two year principal residence out of the final five years test and not lose any of the home sale exclusion.
An IRS Alert!
Home-office deductions tend to be big red flags to the IRS. If the IRS audits you, you could end up owing back taxes and interest on the office expense, if disallowed, plus anything else they found while conducting the audit.
Summary
Talk with your tax and financial professionals before you make any decisions that have important tax consequences. Your planner cannot change the laws, but he or she can help you be flexible in your planning so you do not unexpectedly get a tax door slammed in your face.
Brock and Associates, LLC is a fee-based financial planning firm specializing in tax and business planning. For more information on other tax planning topics, be sure to visit our article archive.
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