Tax Tips
Your Home Office Can Deliver Deductions - March 2009
Richard Scrivanich - Partner
Are you spending a lot to cool your house these days? Have your homeowners insurance premiums shot up? You may be able to cut your effective housing costs by taking partial tax deductions. To do so, you must maintain a qualified home office - and that may be within many taxpayers' reach.
- Example #1: James Thomas lives in a 2,000 square foot house. He maintains one room as a home office; that room measures 150 square feet. James can deduct 7.5% (150/2000) of his home expenses, which may include insurance, utilities, security systems, and home repairs. He can also depreciate that portion of his house. If James' house has 10 rooms of approximately the same size and he uses one for business, he can deduct 10% of his household expenses.
- Alternative: Renters can deduct a portion of the rent they pay, along with other out of pocket expenses.
Principal place of business
There are several ways to qualify for the home office deduction. For example, you can maintain part of your home as your "principal place of business." That's where the most important activities of your business are performed. The principal place of business test is easiest to meet if you have self employment income or run a sideline business from your home. However, your home office deductions can't exceed the revenues from your self employment or sideline business. (You can carry over nondeducted expenses to the next tax year, if that will help.) If you file a Schedule C to report self employment income on your tax return, you can attach Form 8829 to list home office deductions.
If you work as an employee, taking home office deductions is more difficult. You can qualify if your employer requires you to do administrative or management work but does not supply you with an office. Even if you are an employee whose home office qualifies as your principal place of business, however, the tax benefits may be meager. You must list the resulting expenses as miscellaneous itemized deductions on Schedule A of your tax return and can deduct them only to the extent that they exceed two percent of your adjusted gross income.
Other opportunities
If you can't pass the principal place of business test, here are some other ways to qualify for home office deductions:
- Meetings. You must regularly meet with patients, clients, or customers in your home office.
- Separate Structure. If you have a detached garage with an upstairs room, for example, using that room for business may qualify for home office deductions.
Regular and exclusive
Assuming you can pass one of the tests described above, home office deductions are possible. To take the deductions, your home office must be used "regularly and exclusively" for business. The tax code doesn't say what constitutes "regular" use. However, if you have a spare room where you see a client once or twice each year, that probably won't qualify. The more in-house meetings, the better.
In practice, there's some leeway to "exclusive" use of a room. If your kids visit your home office to tell you about school that day, you won't lose your deduction. In fact, a home office needn't be a room; a designated area of your home will do. Moreover, the tax code recognizes some specific exceptions to the exclusivity requirement. If you use a portion of your home to provide day care services or to store business related inventory and samples, exclusive use is not required as long as you meet other conditions. In general, though, it's best to do all you can to keep nonbusiness activities out of your home office.
Payback time
As mentioned, taxpayers who qualify for home office deductions can depreciate a portion of their house. Those depreciation deductions will be taxed when the house is sold.
- Example #2: Jeanne Thomas has a qualifying home office and takes $20,000 worth of depreciation deductions over several years. She sells her house at a $200,000 profit. As a single taxpayer, Jeanne is entitled to a $250,000 capital gain exclusion on the sale of her home.
Even though she qualifies for an exclusion that exceeds her gain, Jeanne still must recognize $20,000 in taxable income on the sale because of her prior depreciation deductions. Generally, that income will be taxed at a 25% rate. Any depreciation allowed or allowable will be subject to this 25% tax bite on a sale. Therefore, Jeanne should take the depreciation deductions when she can. Even though these deductions eventually will result in taxable income, Jeanne will benefit by deferring income tax. In addition, if Jeanne's federal income tax bracket is higher than 25%, she will benefit through tax reduction. She might, for example, take deductions in a 28% bracket and eventually pay tax at 25%.
If you have any questions regarding the above discussed topic, or any other tax matter, please feel free to give me a call at (562) 698-9891.
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