There's probably no federal income-tax break that goes unclaimed as often as the home-office deduction. Some taxpayers are put off by the paperwork they think is needed to prove that their use of the space meets the definition of a home office as a principal place of business. Others fear that by taking this deduction, they may draw the Internal Revenue Service's scrutiny. "A lot of taxpayers sit in front of me and say: `I am afraid of sending up a red flag,"' says Robert Doyle, a CPA and partner at Spoor, Doyle & Associates in St. Petersburg.
But a legislative change that took effect in 1999 may tempt more workers to consider this break, which covers expenses such as home mortgage or rent and real estate taxes. The change makes it easier for taxpayers such as physicians, performers, and consultants to qualify because it has broadened the definition of "principal place of business." Now you may deduct your home office even if you use it only for administrative tasks. Previously, a doctor who spent most of her time seeing patients at hospitals couldn't deduct a home office she used for tasks such as billing, bookkeeping, and setting up appointments. She now can do so if there is no other office available for that purpose.
Home-office deductions cover costs related directly to the physical space as opposed to other business expenses, such as additional phone lines, that can be claimed on the Schedule C form filed by the self-employed (table). Costs for utilities, repairs, and depreciation on a portion of the property all fall under home-office deductions. To qualify, you must work in a separate, defined space that you use "exclusively" and "regularly" for your business. Because of this exclusivity test and fears about raising a red flag, some longtime home-based workers opt not to bother with home-office claims. Take interior designer Susan Dudics-Dean of Martinsburg, W.Va. While she's worked from home for 19 years, she hasn't taken a home-office deduction, although she regularly files Schedule C claims.
But Doyle says the exclusivity test needn't be hard to meet if you define the workspace carefully and make sure you don't use it for anything else. He recalls one client, a general contractor, whose office consisted of "a desk with a computer on it in the dining room, and a drafting board and filing cabinets in the living room." While the office didn't have its own four walls, this client sailed through an audit because those spaces were used exclusively for his work.
To calculate the deduction, estimate the percentage of your residence devoted to the office. Say it's 10%. You'd claim 10% of the cost of your rent, home insurance, utilities, and so forth, as a deduction each year. If the rooms in your home are about equal size, you may assign, for example, one room out of four--and 25% of the expenses--to your home office.
A deduction you may want to study carefully before you take it is the one for depreciation. Claiming that deduction now could cost you money in the future, says Washington tax lawyer Richard Halberstein. Say you sell your house a few years from now at a $250,000 profit. That's the maximum gain a single person ($500,000 for a married couple) can make without triggering capital-gains taxes. But if you've been taking deductions for depreciation on the home-office portion of your house, the total amount that you took for depreciation over the years may be subject to a capital-gains tax of up to 25%, plus state taxes. The larger the proportion of your home allotted to your office, the larger the tax bite might be. The only way to figure out what's best for you financially is have a tax expert do the calculation. All this might seem like a lot of work, but then, it's likely you'll be doing a lot more work from your home office.