That home office you've set up is a real cozy place to get work done. Just don't expect to get a tax write-off, too. These days, it's almost impossible to qualify for a home-office deduction. Even if you think you fall within the rules, it still may not be worth doing.
If you're self-employed, your home office must be used exclusively for business. That means if you're audited, a photo of the room had better not show sofas, TV sets, or personal effects of any kind. A tougher standard grew out of a 1993 U.S. Supreme Court decision that says your home office must be the principal place where you make your money. The ruling, Commissioner vs. Soliman, concluded that an anesthesiologist who saw his patients in a hospital and merely used his office to do paperwork couldn't deduct the office because he didn't perform his trade there. That sharply curtailed the number of taxpayers who could claim a home office.
FORM AND LETTER. If you're an employee, you must prove the home office was set up for the convenience of your employer. Whether you're a new mom on maternity leave or someone who frequently works at home to avoid a long commute, you can't have an office available at your place of business that you simply choose not to use. "Generally, people need a letter from their employer saying it isn't feasible for them to provide office space," says Bernard Kent, a Coopers & Lybrand partner in Detroit.
Still think you qualify for a home-office deduction? You must then file Form 8829. But of 15 million sole proprietorship filers in 1992, only 1.6 million took the deduction. Why? The IRS concedes that claiming a home office increases a return's complexity--and complex returns are more likely to be audited. If you have taken aggressive positions elsewhere on your return, the additional audit risk may not be worth the added deductions.
To calculate potential tax benefits, list all of your expenses as a homeowner that you can't deduct elsewhere. Your mortgage and property taxes are already itemized deductions, so forget them. Your computer and fax costs, phone bills, and furniture would be business expenses even without the home-office deduction. That leaves items such as homeowners insurance, utilities, and exterior maintenance (or rent if you're an apartment dweller).
Let's say your homeowners' insurance is $1,000 per year and your utilities are $1,500. Plus, you spent $20,000 on exterior maintenance--a new roof, painting, etc. Your home has 3,000 square feet, and your office takes up 600 square feet. Your office represents 20% of your home's floor space, so you can deduct $500 of utilities and insurance--20% of $2,500. You can depreciate $4,000 of your exterior maintenance over 39 years, or $103 per year. Thus, your total annual home-office deduction is $603.
For taxpayers in the 31% federal bracket, that's worth just $187. Add a $50 benefit if you're in a high-tax state and an additional $100 when you consider self-employment taxes. But if you're audited, your accounting fees alone could easily exceed $1,000--not to mention the lost deductions, interest, and penalties that could arise if the IRS auditor disallows other unrelated deductions. And if you're an employee, a home-office deduction may be worthless. It falls under miscellaneous itemized deductions, which you can write off only if they exceed 2% of adjustable gross income.
A home office can also foul up two major tax benefits afforded homeowners. One allows you to defer capital gains on the sale of a home if you buy a more expensive one. Let's say you paid $200,000 for a house 10 years ago and it's worth $350,000 today. If you had been claiming a home office of 20% of your square footage, then you would have to pay tax on $30,000 of the gain. That is, 20% will be treated as business property and won't qualify for the rollover provisions that permit you to avoid capital gains as long as you invest in a more expensive house, or the $125,000 capital-gains exclusion you would normally get at age 55.
LESS RISK. Many members of Congress want to reverse the Soliman decision, but if that happens, it won't be before late summer. Then, more people would qualify for the home-office deduction. But they might still find it isn't worth much.
A better option might be to incorporate. True, corporations are not permitted home-office deductions, but there is at least one offsetting bonus: You can deduct all of your medical expenses. As a sole proprietor or employee, you can only deduct medical costs when they exceed 7.5% of your adjusted gross income. That means if your income is $100,000, the first $7,500 in medical expenses are not deductible. If you incorporate, though, you can run your medical costs through the corporation. That's probably worth a lot more than a home-office deduction, without the audit risk.