For years, tax sages have warned that claiming a home office increases your chances of being audited, and the IRS has tacitly gone along with those stories (maybe even exaggerating them, some suggest, to scare home-office workers out of taking the deduction).
In truth, there’s good reason to believe that the home-office deduction flag is fading, as auditors target more fertile ground looking for hidden tax dollars. Self-employment income in excess of $100,000 can still get you a place on the IRS hit list, for example.
But, as the number of legitimate home-based businesses grows, and according to Launchscore.com, a small business opportunity and startup entrepreneur mega site, the IRS’s chances of finding fraud wherever it looks have slimmed. Recent rules and new forms have eliminated a lot of the gray areas that surrounded home-office claims at the same time that many more taxpayers have joined the ranks of home-office workers. If auditing home offices ever was like fishing in a barrel, the barrel has been washed away by the work-at-home tsunami. The IRS could waste a lot of energy and resources auditing the more than 20 million home-based businesses and find a lot of careful record keeping, a lot of legitimately deductible home offices, and not a lot of money owed the U.S. Treasury.
STOP THE PARANOIA
Many people (including my brother) have been so put off by the red-flag fear and the putative complexity of the home-office deduction that they have declined to take it, even though it can be worth hundreds or even thousands of dollars in saved taxes. By some estimates, only about four million Americans take the tax break, even though five or six times that number may work at home.
Rumors (largely unconfirmed) about the pettiness of IRS auditors have increased those fears. My personal favorite is the one about the auditor who found personal mail in the waste basket of a home office and disallowed the office because it wasn’t used “exclusively” for business.
How realistic is this apocryphal story? Not very. Frederick Daily, a San Francisco home-based tax attorney and author of Stand Up to the IRS (Nolo Press), claims that in 20 years of representing small businesses, he has never had an auditor ask to examine one of his clients’ home offices. The two homeworkers I know who did undergo sustained home audits say the IRS examiner never questioned the legitimacy of the home offices once he saw that the rooms looked like bona fide offices. In other cases where home offices were questioned at audits that took place away from the home, a few pictures or a photocopied floor plan were enough to save the office deduction from the clutches of the IRS.
My favorite home-office audit story comes from Scot Ogle, a Boulder, Colorado, television producer. Despite the fact that Ogle drew an “auditor from hell” who tied up his taxes for four months and even questioned the exclusivity of his stapler, the questions about the home office were kept to a minimum. Ogle had taken pictures of his home office, which his accountant passed on to the IRS, but it was our magazine cover story that sold the auditor.
“The guy was very impressed by that,” says Ogle. “He said, ‘Oh, I guess we don’t have to question it.'”
THE EXCLUSIVITY TEST
The bugaboo for many home-based workers is the exclusivity test. If you take the deductions associated with having an office in your home, you are supposed to use the office exclusively for your business. It can’t be a family game room or the dining room when it isn’t being used as your business office.
Does this mean that you are not allowed to pay personal bills while sitting at your desk? Or should you not keep Tetris on your computer? A stickler would say yes, but a more practical person would note that even corporate employees sometimes bring their bills into work or play a quick computer game on their coffee break. “There is a certain blurring,” says Ogle. “I bought my stapler for my office. I keep it there and use it in my business. But who is to say my wife didn’t walk in one day and staple some papers together?”
Daily points out that even if you are the subject of a rare home audit, you’ll have ample time to “cleanse” your office of offending paraphernalia before the auditor arrives. “What kind of idiot couldn’t rearrange things to take the personal items out?” he asks.
This does not mean that you should run your home office out of an actively used family room or guest room, or that you should take a write-off for the kitchen table. The fact that it jeopardizes the legality of the home-office deduction is secondary; what’s more important is that it’s very hard to run a profitable business in a room that isn’t set up and available to you as a place of business.
RECAPTURE YOUR TAX DOLLARS
There’s a second reason why legitimate home-office workers sometimes decline to take the home-office deduction: They’ve been told that if they sell the house, they’ll have a greater tax burden.
Here’s the truth: If you sell a residence and buy another, you can roll over the gain you’ve made on the house you are selling into the house you are buying (that is, if you even have a gain–a lot of people are facing losses instead when they sell their homes). You won’t have to pay a capital-gains tax until you sell your last house or start down-sizing and buy a house worth less than the house you are selling. Furthermore, if you wait until you are over 55 to do that down-sizing, you may be able to exclude the first $125,000 of gain.
But if you have depreciated a portion of your house, condominium, or co-op as an office, that portion is considered business and not residential. So you can’t roll over the capital gain; you have to pay tax on the prorated portion of it that represents the home-office deduction you’ve taken.
However, there is a way around this, too. Move your office out of your home in the year that you sell your home and don’t take any deduction for your home office–neither depreciation nor utilities–in that year. At the same time, suggests Daily, rent an office elsewhere. Then you’ll have real documentation to show that you don’t have an active home office while you are selling your house, which is all that you really need to stay on the right side of the IRS recapture rule.
TAKE IT, IT’S YOURS
So stop worrying about the home-office deduction and start enjoying this one real break you get as a self-employed home-based businessperson. Follow these eight timely tips to keep your deductions clean and profitable.
Use fonn 8829, “Expenses for Business Use of Your Home.” This is an IRS income-tax form that first appeared in the 1991 tax package. It will walk you through every calculation related to the business use of your home and keep you from making mistakes. It may even remind you of related deductions you might otherwise skip. And for sole proprietors (those of you who file IRS Schedule C to report your income), it’s the only way to get the home-office deduction.
Measure your office. Your deductions will be prorated by the percentage of your home’s square footage that is used as office. Although the IRS instructions suggest you can use square feet, number of rooms, or “any other reasonable method” of comparing your office space to the total space available in your home, it’s the square footage that agents seem to feel most comfortable with. When Amherst, Massachusetts, musician Paul Kaplan’s brick-lined home studio was audited, the examiner knew at a glance that the dimensions claimed on the tax form were a little off. Why? It turned out the auditor’s father had been a bricklayer and had taught his son how to estimate space by counting bricks. (It also turned out that the auditor was himself an aspiring folk musician who took a more sympathetic approach to Kaplan’s guitar-strewn office than another examiner might.)
Take all the related deductions. Your home office entities you to depreciation or deducting a portion of your rent. The deduction also entitles you to prorate your utilities (except your phone service). If you own your home, you can prorate and deduct the business portion of your mortgage interest and property taxes. Although those two items are deductible elsewhere on your income taxes anyway, they are worth more on the Schedule C, where Form 8829 totals are reported, and where they can offset the 15.3 percent self-employment tax.
Consider remodeling. If you’ve been tempted to remake the attic into a real office complete with built-in shelves, new staticproof carpeting, and glare-free recessed lights, go for it. New construction to create a home office may be 100 percent deductible in the year you do the construction under Section 179 of the tax code. This section enables you to take up to $10,000 of your depreciable expenses in the year you incur them. (See my column in the November 1992 issue for more on the Section 179 deduction.)
Stake out your space. Having a room that is yours and yours alone is a luxury. However, you are allowed to take a deduction if your home office is only a portion of a room–a desk in the corner of your bedroom, for example. If that’s all the space you can spare for your home office, do all you can to keep it separate. If you don’t like the fabric screen approach, pile file boxes around you or stick a line of tape on the floor to keep other family members away from your office space.
Be too legit to hit. Even though you don’t have to police the wastebasket, the more exclusive your office is, the better. At best, you’ll avoid the problems of one work-at-home mother whose very young child got so used to playing video games on her computer, he kept putting quarters in the disk drive when she wasn’t around. Take pictures of your home office, or keep a schematic of your floor plan (with home-office dimensions) on file in case of an audit.
Think twice about incorporating. For some inexplicable reason, the home-office deduction is available only to sole proprietors and not one-person corporations. Any way you try to do it, including leasing space to the corporation, ends up banging into a regulatory roadblock.
Avoid computer games in the office. Don’t put Tetris or any other game on your business computer. Chances are, the IRS auditor will never even get a peek at your hard-disk drive. But the game will ruin your profitability nevertheless. Take it from someone who knows.