Strict Rules Govern Deductibility of Home Office Expenses
Advice — on the House
By CAROLYN BOURGOIN, CPA
Many of us find ourselves working from home, either out of necessity or by choice. Both self-employed taxpayers and employees can qualify for a home office deduction for the business use of their residence as long as they have met a set of strict conditions.
Employees in particular will have a more difficult time passing all the tests necessary to qualify, because they have the additional requirement of proving that the home office is for the convenience of their employer.
In order to qualify, a taxpayer must use the home office space on a regular and exclusive basis as one of the following:
• A principal place of business;
• A place for meeting or dealing with clients, patients, or customers in the normal course of business; or
• In connection with the taxpayer’s trade or business, if the home office space is a separate structure from the residence, such as a detached garage.
Regular and Exclusive Use
The regular-use and exclusive-use requirements of a home office are separately examined to determine if the conditions are satisfied.
An IRS publication states that regular use is satisfied when a specific area is used for business on a continuing basis. Though a space may be used exclusively for home office use, the occasional or incidental use of the space is not sufficient to qualify.
In Christensen v. Comr, an international marketing manager was not allowed to deduct his home office expenses because he could not substantiate the frequency of meetings with clients. It is therefore important that a taxpayer be able to show continuity of use of the home office space through some credible means, such as a written log.
In order to meet the exclusive-use requirement, the home office space must be a portion of a dwelling unit that is used solely for carrying on the taxpayer’s trade or business. There is no requirement that the identifiable space be a separate room or a permanently partitioned area of a room.
However, where only a portion of a room is used and there is personal-use furniture in the room, the taxpayer will have a more difficult time establishing exclusive use. Even minimal personal use of the business portion of a residence may result in the home office failing to meet the exclusive-use test.
There are two exceptions to the exclusive-use rules, one of which relates to the storage of inventory if the home is the sole location of the trade or business, and the other to certain daycare facilities.
Where a taxpayer uses a home office for two different business uses, each business must qualify under the home office rules, or the related deductions will be disallowed.
As mentioned earlier, the regular and exclusive use of the space must be in connection with one of three categories of business use, the first of which is the principal-place-of-business standard.
When the home office is used on a regular and exclusive basis as the principal place of business of the taxpayer, then the related home office expenses will be deductible (subject to a gross income limitation). The principal-place-of-business test mainly benefits self-employed individuals who work out of their homes as well as employees whose employers do not provide them with office space.
Determining the principal place of business is often a highly contested matter when a business is conducted at more than one location. With the exception of administrative or managerial duties performed at a home office (discussed below), a home office found to be a secondary place of business will not afford the taxpayer a home office deduction.
The courts have taken into account two main considerations in determining the primary location of a business when a taxpayer works both at home and at another location. One consideration is the relative importance of the business activities of the taxpayer at each location, and the second is the time spent at each location.
For instance, an insurance salesman uses a home office to prepare for meetings with potential clients. He meets with clients at their locations and closes his deals there. In this situation, the more important business activities of the taxpayer take place in the meetings at the client’s place of business. The home office is not the principal place of business.
A home office may also qualify as a principal place of business if it is used exclusively and regularly for administrative or managerial activities of a taxpayer’s trade or business where the taxpayer has no other fixed location of conducting substantial administrative activities. Legislative history shows that, when a self-employed taxpayer has an option to use an administrative office away from home but chooses to use office space at home to perform the administrative duties, the taxpayer can still qualify for the home office deduction.
In contrast, if the taxpayer is an employee as opposed to self-employed, failure to use available office space offered by his or her employer will be factored into whether an employee’s home office meets the convenience of the employer requirement. It is therefore more difficult for an employee to get a home office deduction where it is used for administrative activities.
Separate-structure Test and Separate-meeting-place Test
If a taxpayer’s home office use does not meet the principal-place-of-business test, the space can still qualify for the home office deduction where it is used regularly and exclusively to meet and deal with clients or patients or if it is a separate structure from the residence and used regularly and exclusively in the taxpayer’s trade or business.
In order to use the meeting-place test, the office space must be used to physically meet with clients, and the use of the space has to be integral to the employer’s business. With respect to the separate-structure test, there is no requirement that the taxpayer meet with patients or clients. An artist’s studio, greenhouse, or carpenter’s workshop could qualify. As with the principal-business test, an employee must show the use is for the convenience of his employer to meet either the separate-structure test or the client-meeting-place test.
Anyone who is considering the home office deduction needs to assess whether the potential deduction is worth the record keeping (i.e. regular and exclusive use support) and the risk of an audit. An employee who qualifies will not receive a tax benefit unless the home office deduction, along with other miscellaneous itemized deductions, exceed the 2% floor of the employee’s adjusted gross income.
The amount of the home office deduction is also subject to limitations that are based on the income attributable to the taxpayer’s use of the home office. Additionally, if the residence holding the home office is later sold at a gain that would otherwise have been excluded from income tax under the principal residence exclusion ($250,000/$500,000), a portion of the profit equal to the amount of depreciation claimed on the home office will be taxable.
There are benefits to having a home office, but be sure to evaluate its use carefully when considering claiming this deduction. As always, be sure to speak with your tax professional if you have any questions.
Carolyn Bourgoin, CPA is a senior manager with Holyoke-based public accounting firm Meyers Brothers Kalicka, P.C.; (413) 322-3483; [email protected]