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The
cost of operating an office from home is a business tax deduction if the
office is the principal place of business for the taxpayer. It need
not be the principal place of business for the taxpayer's main activity; a
deduction applies as long as the home office is the principal place of
business for the sideline activity.
Using
a home office for substantial administrative or managerial activities, such
as keeping records, scheduling appointments and preparing proposals, allows
it to be treated as a principal place of business, even if the revenue is
generated at another location.
What
activities amount to a business? You should know that a sideline activity,
in some cases, might not be treated as a business. Those who hold real
estate investments and those who buy and sell securities represent two
problem areas.
In
the case of real estate investments, holding even one property may amount to
a business, depending on the level of the taxpayer's activities. The
Tax Court has held that a taxpayer's activities constituted a business where
he sought new tenants, cleaned and prepared the six units he owned, and
provided furnishings for them.
In
the case of securities, deductibility depends on whether the taxpayer is
considered to be an investor or a trader. Occasional trades and
long-term positions indicate investor status for which a home office
deduction would not be allowed. In contrast, someone who spends
substantial time managing a sizable portfolio and seeking short-term profits
is usually considered to be a trader for whom a home office deduction would
be allowed.
The
home office must be used regularly and exclusively for the business;
personal use of the space when it is not being used for business precludes
the deduction. The space need not be a whole room or even physically
partitioned from the rest of the home, however its business function must be
respected. For example, a sideline business can be run from a corner
of a finished basement, however the space cannot double as a children's rec
room by day and home office by night.
How
important is the home office deduction? It can be quite important
because it is a way to convert nondeductible personal expenses into
deductible business expenses. For example, a taxpayer that leases his
residence is paying rent, utilities and maintenance. With a home
office deduction, a portion of these costs become deductible. More
specifically, the deduction is composed of both direct and indirect expenses
attributable to business use of space within the home. Direct expenses
are those items attributable to the home office, such as painting the
space. Indirect expenses are those items that relate to the entire
home, such as painting the exterior of the home. The portion of
indirect expenses related to the home office is part of the home office
deduction. The allocation generally is made on a square footage
basis. For example, if a home is 2,500 square feet and the home office
is 250 square feet, then 10% of indirect expenses are part of the home
office deduction. The allocation of indirect expenses can also be made on a
per-room basis if the rooms are approximately the same size.
In
the case of depreciation for those who own their home, the deduction is
figured on the home office space. The basis for depreciation is cost
or fair market value, whichever is lower. Since most homes appreciate,
the home's cost typically determines basis. For example, say a
taxpayer uses 10% of his home for business. He paid $200,000 for the home
ten years ago, exclusive of land. Today, it's worth $400,000.
His basis for depreciation if $20,000 - 10% of $200,000. Additionally
the amount of depreciation is based on a 39-year recovery period. The
percentage used for depreciation depends on the month in which the space is
first used for business. So if the taxpayer in our example starts to
use the home office in October, his first-year depreciation allowance is
$107 and his depreciation allowances for the next 39 years are $512.80 (an
additional amount in allowed in the 40th year), assuming he still owns the
home and uses the home office at that time.
The
catch with claiming a home office deduction is that the write-off cannot
exceed "gross income" from the home office activity. For
this purpose, gross income means net profit as reported on Schedule C if the
taxpayer is a sole proprietor, reduced by the allocable portion of mortgage
interest, real estate taxes, and casualty losses, if any. Deductions
for these items are used to offset gross income first. If there is any
excess gross income, then it is offset by homeowner's insurance premiums,
repairs and maintenance, utilities, and rent. Finally, if there is
still excess gross income, it can be offset by depreciation.
If
expenses are disallowed because of the gross income limitation, they can be
carried forward and treated as part of home office expenses the following
year. There is no limit to the carryforward period.
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