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Michael Redemske

Do You Qualify for a Home Office Deduction?

Take this short quiz and find out.

October 13, 2011
by Michael Redemske, CPA

With unemployment at the highest rate in recent memory, it is not surprising to find many people working out of their homes on a full- or part-time basis. Now may be a good time to review the criteria for claiming a deduction for the business use of part of a person’s residence. Those who qualify for the so-called home-office deduction are able to write off the direct and indirect expenses incurred in maintaining a room or part of the home that is set aside for business use.

The process for determining the amount of deductible home-office expenses is similar to the process used to determine the deduction for vacation homes. Gross revenue from the business is included in gross income. Business expenses unrelated to the home are fully deductible. Expenses associated with the home are allocated between nonbusiness use and business use.

Expenses attributable to nonbusiness use are not deductible, except when they qualify as itemized deductions, such as mortgage interest expense and real-property taxes.

When gross business revenue exceeds the sum of business expenses unrelated to the home (not including the deduction for one-half of the self-employment tax) and business expenses related to the home, the business expenses relating to the home are fully deductible. However, when the total business expenses exceed the gross business revenue, the deduction of the expenses is limited.

When the limitation applies, the business expenses related to the home are divided into three tiers:

  • Tier 1 expenses consist of expenses attributable to business use that the taxpayer could deduct even if the home was not used for business, such as home mortgage interest and real-property taxes.
  • Tier 2 expenses include all other expenses attributable to business use of the home, except depreciation.
  • Tier 3 expenses consist of depreciation.

Tier 1 expenses are deducted in full, even when the result is a loss. Tier 2 business expenses can only be deducted if a profit remains after deducting the Tier 1 expenses and business expenses unrelated to the use of the home. The deduction of the Tier 2 expenses cannot produce a loss. Any Tier 2 expenses that are nondeductible because of the net-income limitation are suspended and carried forward to the next year, subject to the same limitations. If any profit remains after deducting the Tier 2 expenses, the Tier 3 expenses are deducted, up to the remaining amount of profit. Tier 3 expenses in excess of the net-income limitation are suspended and carried forward to the next year, subject to the same limitations.

Note that any depreciation deductions reduce the tax basis in the home. Any gain on the subsequent sale of the home caused by the depreciation deduction is not eligible for exclusion under the home sale exclusion provisions. Rather, the gain is subject to a maximum 25-percent tax rate.

Can You Claim a Home Office Deduction?

To find out if you qualify for a home office deduction, answer the following questions:

  1. Is your home office used in a trade or business activity?

    You cannot take a deduction if you use your home for a profit-seeking activity that is not a trade or business. For example, if you use part of your home to manage your personal investments, you cannot take a home-office deduction.
  2. Do you regularly use your home office exclusively for business?

    You must regularly use a room or other separately identifiable area of your home only for your business. You do not meet this requirement if you use the area for both business and personal purposes. For example, an attorney who writes legal briefs at the kitchen table cannot claim a home-office deduction.

    Here is another example: Luis runs his own tax-preparation business out of his home. Luis operates his business out of a spare bedroom, where he regularly meets with clients. At the end of a hallway leading to his home office, Luis constructed a bathroom for his clients’ use. His children occasionally use the bathroom. The bedroom meets the test for the deduction; but the hallway and the bathroom fail the “exclusive use” requirement.

    You do not have to meet the exclusive use test if you use part of your home to store inventory or product samples or as a day-care facility.
  3. Is your home your principal place of business?

    If you conduct business at more than one location, you determine your principal place of business based on the relative importance of the activities performed at each location, or the time spent at each location. Your home office also will qualify as your principal place of business if you use it regularly for administrative activities and you have no other fixed location where you conduct substantial administrative activities.
  4. Is your home used as a place to meet with patients, clients or customers in the normal course of your business?

    Doctors, attorneys and other professionals who maintain offices in their homes will generally meet this requirement. Using your home for occasional meetings and telephone calls is not sufficient. However, the part of your home you use exclusively and regularly to meet patients, clients or customers does not have to be your principal place of business.
  5. Is the portion of your home used for business activities a separate structure not attached to the dwelling unit?

    You can deduct expenses for a separate free-standing structure, such as a studio, garage or barn. The structure does not have to be your principal place of business or a place where you meet patients, clients or customers. For example, John operates a floral shop in town. He grows the plants in a greenhouse behind his home. Since he uses the greenhouse exclusively and regularly in his business, he can deduct the expenses for its use.
  6. If you are an employee, do you use your home office for the convenience of your employer?

    Whether your home's business use is for your employer's convenience is a factual question.

    Consider the following example: As a teacher, Kathleen is required to teach and meet with students at the school and to grade papers and tests. The school provides her with a small office where she can work on her lesson plans, grade papers and tests, and meet with parents and students. The school does not require her to work at home. Kathleen prefers to use the office she has set up in her home and does not use the one provided by the school. She uses this home office exclusively and regularly for the administrative duties of her teaching job. Because her employer provides her with an office and does not require her to work at home, she does not meet the convenience-of-the-employer test and cannot claim a home office deduction.

So how did you make out? To claim the deduction, you must have answered “yes” to both questions one and two. You must have also answered “yes” to at least one of questions three, four or five. Finally, if you are an employee, you should have answered “yes” to question six.

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Michael R. Redemske, CPA, is an instructor in residence at the University of Connecticut where he teaches federal income taxes and personal financial planning.